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!
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.
