You Decide To Sell Short 100 Shares Of Charlotte Horse Farms

4 You Decide To Sell Short 100 Shares Of Charlotte Horse Farms When

Decide to short 100 shares of Charlotte Horse Farms at its yearly high of $56, with a margin requirement of 45%, a commission of $155 on the short sale, a dividend of $2.50 per share during ownership, and closing the position after one year by buying at $45, with a commission of $145 and an 8% interest on borrowed funds. Calculate the rate of return on this investment.

To determine the rate of return, first, compute the initial proceeds from short selling, the total cost of dividends paid, the total amount spent to buy back shares, including commissions and interest, and then evaluate the profit or loss relative to the initial investment.

Paper For Above instruction

Selling short involves borrowing shares to sell at the current market price, intending to buy them back later at a lower price, profiting from a decline in stock value. In this scenario, the process begins with shorting 100 shares of Charlotte Horse Farms at $56, the year's high. The initial proceeds from the short sale are calculated by multiplying the 100 shares by the sale price: $56 × 100 = $5,600. Since the broker requires a 45% margin, the investor must deposit 45% of the total short sale value, which is $5,600 × 0.45 = $2,520. This ensures the broker's collateral coverage for the borrowed shares.

The commission on the short sale, paid upfront, is $155, which is an immediate transaction cost. During the period of holding the short position, the investor receives dividends of $2.50 per share, totaling $250 (100 shares × $2.50). Since the investor is short, they are responsible for paying dividends to the lender, which adds to the total costs.

After one year, the investor closes the position by purchasing 100 shares at $45 each, costing $4,500. The purchase incurs a commission of $145. The borrowed funds used to buy back shares accrue interest at 8% annually, on the borrowed amount. The borrowed amount is primarily the proceeds from the initial sale, which is $5,600; the interest cost over one year is $5,600 × 0.08 = $448.

Calculating the total costs and proceeds:

- Initial proceeds: $5,600

- Total dividends paid: $250

- Purchase cost: $4,500

- Purchase commission: $145

- Interest expense: $448

Total expenses (considering proceeds and costs):

Total costs = Purchase cost + Purchase commission + Interest + Dividend payments = $4,500 + $145 + $448 + $250 = $5,343

The net profit or loss is:

Proceeds from short sale = $5,600

Less total costs = $5,343

Net profit = $5,600 - $5,343 = $257

Finally, to determine the rate of return:

- Initial margin deposit (own cash): 45% of $5,600 = $2,520

- Total profit: $257

- The investment’s return = (Net profit / initial margin deposit) × 100 = ($257 / $2,520) × 100 ≈ 10.22%

This percentage reflects the rate of return on the investor’s initial margin amount invested.

Therefore, considering all costs, dividends, and interest, the investor earns approximately 10.22% return on the margin amount over the year. This illustrates how short selling can be profitable but involves risks like dividends and costs associated with borrowing, emphasizing careful risk management and attention to timing and market movements.

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