“Because the long and short positions together constitute a riskless position, the investor will earn a money market rate of return on the $100 million position”
“The net cost of borrowing through a short sale against the box is quite low because the interest income earned on the completely hedged stock position greatly offsets the interest expense associated with the margin loan.”
The above two statements in Section 4.3.1.1 reference the income one can earn on a short sale against the box. I understand how the equity position is transformed into a riskless asset and that there will be interest expense on the margin loan and borrowing costs. What I do not understand is how the riskless position generates a money market ROR absent borrowing against it. Furthermore, there is no mention of the cost to borrow the shares.
I understand that, but the way the statement is worded is exclusive of a subsequent decision to invest the cash proceeds. As worded, there is an implication that a riskless combination of long shares + borrowing shares then selling them short is somehow an interest income generator.
That is the part that I do not understand. Unless it is just worded imprecisely and the risk-free ROR on the cash proceeds is just assumed to be a part of the transaction. The problem then becomes that the purpose of the cash proceeds is to “invest in a portfolio of securities and other investments to achieve diversification” which would disallow them from being used to achieve a risk-free ROR or “money market” return that would cover the margin lending costs and offset the share borrowing costs.
I submit that you’re misreading it. Or, at least, misunderstanding it.
Nobody in finance – _ nobody! _ – is going to advocate getting cash and stuffing it in your mattress. You always – _ always! _ – invest it at the risk-free rate. This idea is fundamental, and need not be repeated every time a strategy that generates cash is described.
Okay then the decision to invest the cash at the risk free rate is implied, which I can understand. The problem then becomes that the original statement is that the purpose of the cash proceeds is to ”invest in a portfolio of securities and other investments to achieve diversification.”
That would disallow them from being used to achieve a risk-free ROR or “money market” return that would cover the margin lending costs and offset the share borrowing costs.
If you generate $10mm from a short sale ignoring share borrowing costs, you cannot simultaneously invest the $10mm cash proceeds in a money market AND invest them in a "portfolio of securities and other investments to achieve diversification.” Do you see where the confusion arises? It seems the reading is double counting the cash proceeds from the short sale