Capital Market limitations: on constraints to reducing concentrated positions

[pianok]

Ok here’s where Shweser lost me… In the chapter of concentrated single asset positions, one of the constraints of reducing a concentrated portfolio, is the Capital Market limitations. I did not get any of it, can someone kindly explain? Is it further explained in other parts of the curriculum?

[cpk123]

see if this helps

3.3.4 Capital Market Limitations

Certain characteristics of the underlying stock ultimately determine the feasibility of hedging different concentrated positions and in what degree they can be hedged.

The ability to borrow shares is critical because the dealer needs to manage the risk inherent in being a counterparty to the investor’s hedge. Managing this risk is achieved by first locating and borrowing the shares and then selling those shares in the marketplace. Although the investor executing the hedging transaction with the dealer could make its long shares available for the dealer to borrow if the shares were not restricted in any manner, the tax authorities could potentially view the transaction effectively as a sale.

In addition, the liquidity of the stock is vital because the dealer will periodically adjust its hedge, either borrowing and shorting additional shares or buying back shares and covering some of its outstanding short position. The average daily trading volume of the stock is important, and the dealer will observe whether the shares have had a propensity to “spike” either up or down. Because of this, most dealers will not execute collars or use other hedging techniques with respect to shares of a company that has recently undergone an initial public offering (IPO) because the dealer wants to be able to observe an established trading history/pattern of the stock prior to entering into such a transaction.

Can you borrow the shares? If so you can enter into a hedge with the borrowed shares. Any restrictions on the ability to borrow the shares could makes the transaction be considered a sale - and in that case - tax laws get applied.

Even if you borrowed the shares, entered in to the hedge to offset your concentrated stock position - over time the hedge needs to be continually adjusted (the hedge is not a one time set up and forget type of transaction). So the liquidity of the stock - being able to return shares back to the market as needed, and get more if needed is also important.

[EugeneNYC]

That point about ‘Capital Market Limitations’ is not very clear to me, especially the interaction with the dealer.

I am the owner of a concentrated position in a public stock. To hedge against decrease in price, I short my stock against the broker/dealer (assuming short is allowed). The dealer must borrow (long) the stock to face me in this deal.

• if the dealer cannot borrow the stock, he cannot face the owner of the concentrated position, who therefore cannot hedge his position (assuming derivatives are not allowed).

Is my understanding correct?

[Harrogath]

@EugeneNYC

That point about ‘Capital Market Limitations’ is not very clear to me, especially the interaction with the dealer.

I am the owner of a concentrated position in a public stock. To hedge against decrease in price, I short my stock against the broker/dealer (assuming short is allowed). The dealer must borrow (long) the stock to face me in this deal.

• if the dealer cannot borrow the stock, he cannot face the owner of the concentrated position, who therefore cannot hedge his position (assuming derivatives are not allowed).

Is my understanding correct?

I think you meant the owner of a concentrated position borrow from a dealer a quantity of the shares the investor currently has. The investor will immediately sell the borrowed shares and invest the proceeds in a diversified portfolio. The investor is still long its concentrated position but it is offset by the diversified portfolio (from borrowed shares). This strategy is called “short sale against the box” and is commonly used when the investor want to reduce the concentrated risk of the position and when the investor is not ready to sell her shares. Also, this strategy can be used when the investor expect a temporary fall in the value of the shares and want to hedge the losses.