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Question 1

When investing in a security, investors EXPECT ….

Answer 1

a financial return made up of current income received (dividends) and capital appreciation (increase in share price)

Question 2

Before investing what three questions should you ask?

Answer 2

1) Is the market (or the stock) ‘overvalued’ (too pricey);
2) Is the market (or the stock) ‘overvalued’ (too pricey);
3) Is the market (or the stock) ‘undervalued’ (underpriced).

Question 3

Long position (2)

Answer 3

1) Your potential gain is unlimited since there is no ‘limit’ on how much a stock price can appreciate (‘sky is the limit’).
2) Your potential loss is limited to 100% of you investment (all is lost, e.g. the firm went bankrupt).

Question 4

Explain a short position? (3)

Answer 4

-Your broker finds someone willing to lend you the security;
▪ You sell the borrowed security at the prevailing market price;
▪ Later you buy it at a lower price and pay back your stock loan.

Question 5

Short selling (2)

Answer 5

● Your potential gain is limited to 100% of your short position
(the security price goes to zero, e.g. the firm went bankrupt).
● Your potential loss is unlimited (since there is no ‘limit’ on
how much a stock price can appreciate).

Question 6

Complication of short selling (3)

Answer 6

1) Dividends
2) Close out
3) Margin requirements

Question 7

Complication of short selling - Dividends

Answer 7

● If dividends are declared, the short position has to pay such dividends to the stock lender.

Question 8

Complication of short selling - Closeout

Answer 8

The stock lender has the right to get ‘reimbursed’ (i.e. get the shares back) at any time, requiring finding a new stock lender or having to buy the shares at the prevailing market price…

Question 9

Complication of short selling- Margin requirements

Answer 9

● Given the potential for large losses, short positions are
required to be covered by an appropriate margin at all times.
● E.g. 150% of the market value of the short position has to be provided at all times with collateral (in cash or otherwise).

Question 10

Economic purposes of short selling - Economic rationale (3)

Answer 10

1) Allows for investors with a bearish perspective the incentive to participate in the market
2) Selling influences price. Helps “price discovery”
3) Short-selling is published and help as indicators of the economic outlook for the given stock