SHORT SELLING
Borrowing of assets in margin accounts is used to initiate short positions.
The asset borrower is usually charged interest on the value of the Asset being borrowed, in addition to paying to the asset lender any income generated by the asset during the loan period.
Dividends or interest derived from a borrowed asset and paid by an asset borrower to an asset lender are referred to as “manufactured”.
The asset being borrowed is returned to the asset lender at the end of the asset loan.
Asset loans play an important role in creating liquidity and facilitating settlements in inter dealer markets.
A short position is initiated by (i) borrowing an Asset and (ii) immediately selling the borrowed asset in the market.
Once she has established a short position on margin, a short seller benefits from price decreases in the asset – after which she can repurchase the asset at a lower price and return it to the asset lender.
Increases in the asset price create losses for the short seller, requiring a repurchase of the the asset at a price higher than the cash received when initiating the position. Potential losses from short positions are unlimited as a result of price increases.
Asset lenders can usually close positions of asset borrowers by requesting the asset to be returned, thus forcing the asset borrower to repurchase it in the market to close the short. If the asset is i-liquid and extensively shorted, this can lead to a short squeeze, where short borrowers scramble to buy back borrowed assets causing large price increases in the asset.