Assignment X1 Question 4(iv)

[Alice G]

Hi,

I am looking at the solution for question 4(iv) in assignment X1, about banning short selling. The final line states that "Market participants can achieve the same effect [as short selling] through swaps, for example, by taking out a swap that pays the total return on the bond or share in return for LIBOR".

I understand this in the context of a bond, because if the price of a bond decreases, the yield increases, so you would benefit from an increased return through the total return swap. However, I don't quite understand for an equity - if the share price goes down over the period of the swap, would this not mean you would get a lower return via the total return swap (while oppositely you would benefit from the decreased share price via short selling)?

Thanks!

 

[Colin McKee]

Hi, You are certainly correct about the swap on the bond - but the same idea applies on any asset. For example, if a trader undertakes a swap to pay the total return on asset A in return for fixed (or LIBOR), then essentially they have shorted the asset. If the asset rises and gives large positive returns, then the pay leg of the swap is a liability to the swap owner. In other words they make a loss when asset A rises. If asset A falls in value and gives negative returns then the "pay" leg of the swap becomes a "receive" leg so the swap owner gets a positive return. ( This is the same as if the trader had short sold asset A.