45.e: Comparing positions investors can take in an asset
Position in an asset refers to the quantity of an asset an investor holds. There are two types of positions:
• Long position: It is the position in which the investor owns an asset or contract and makes a profit when the price of asset/contract increases. The potential gain in a long position is unlimited (the price can rise to any level).
• Short position: It is the position in which investor sells an asset she doesn’t own and makes a profit if the price of asset/contract declines. The potential gain in a short position is limited to the amount received by selling the contract (assuming the price of asset declines to zero).
For e.g. an investor who has bought gold and is holding it over a period of time in hope of making a profit from rising gold prices would be “long on gold”. However, if she thinks the prices may decline in future, she may sell it in futures markets and would be “short on gold”. Such positions are used by investors to hedge their asset exposures as well.
Positions in futures and forward markets
An investor with a long position in the future or forward market would be liable to take physical delivery or cash equivalent of the position at the expiry date of the contract.
Similarly, an investor with a short position in the future or forward market would be liable to make physical delivery or pay cash equivalent to the position size at contract expiry.
Position in options market:
• Long on call option position will benefit from a rise in underlying asset’s price
• Long on put option will benefit from a decline in underlying asset’s price
• Short on call option will benefit from decline in underlying asset’s price
• Short on put option will benefit from a rise in underlying asset’s price
Swap contracts are contracts where the parties involved agree to swap or exchange the cash flows from an underlying asset. There is no buying or selling involved here but generally, the side gaining more is referred to as the long position.
Currency contracts are contracts where the investor buys (or goes long on) one currency and sells (or goes short on) another currency)
Short positions in contracts are created by selling contracts that the trader doesn’t own. The short position in securities is built by borrowing the security from current holders (those long on security). The short seller would then want to repurchase the security when its price has declined so as to make a profit but depending on market condition she may have to buy it back at a higher price (and make a loss) if the price of the security goes up. This act of buying back the shorted security is called short covering.
Security lending agreementa aim to protect the interest of security lender in short positions. Payment-in-lieu of dividend (or of interest) is a payment that the security lender would have received had she not lent the security to the short seller. These agreements also protect the lender in case there is stock split.
To ensure short sellers return the security, lenders also demand that the proceeds from short selling be kept with them as collateral for the security loan. They earn an interest rate on this collateral and give interest rebates to the short seller at rates known as short rebate rates. These rebates are generally given to very large institutional investors. The driving force for security lenders to lend stock is that the short rebate rate remains below the interest rate they earn on the collateral money.
Check your concepts:
(45.15) In the process of short covering, the securities are:
(a) Bought
(b) Sold
(c) Borrowed
(45.16) The short rebate rate given to the short sellers by the security lenders is most likely to be:
(a) Equal to the interest rate earned on the collateral put up for the borrowed securities
(b) Higher than the interest rate earned on the collateral put up for the borrowed securities
(c) Lower than the interest rate earned on the collateral put up for the borrowed securities
(45.17) Which of the following positions are least likely to have the similar returns?
(a) Long forward position and long put position
(b) Long call option and short put option
(c) Short put position and long forward position
Solutions:
(45.15) Correct Answer is A: The securities that were borrowed from the lenders and were shorted by the security borrowers are bought back in the process of short covering.
(45.16) Correct Answer is C: The short rebate rate is generally lower than the interest rate earned on the collateral put up for the borrowed securities.
(45.17) Correct Answer is A: A long put position benefits from a decrease in the underlying price whereas a long forward position benefits from an increase in the underlying price.
Exam Alert: The candidates should be comfortable with the long and the short positions in different instruments and how the payoff of these position depends on the movement of the underlying securities.
