Question

Check all that apply:

A) Among the risks associated with short selling a stock are:

- Default risk: potential unlimited losses when buying back the stock.

- Regulatory risk: a ban on short sales can create a surge in the stock price.

- Dividend risk: the short seller must provide dividend payments on the shorted stock to the entity from whom the stock has been borrowed.

- Systematic risk: the uncertainty inherent to the market as a whole and which cannot be diversified.

B) Leveraging your portfolio: (check all that apply)

- Allows you increase your return on equity, magnifying positive (or negative) returns by borrowing money.

- Increases your default risk by magnifying the standard deviation (risk) of your portfolio.

- Does not increase the standard deviation of your portfolio, since the borrowed money is risk free and therefore has a standard deviation of zero.

- Increases systematic risk within your portfolio, that is the uncertainty inherent to the market as a whole and which cannot be diversified.

Answer 1

Answer-

Q A)

The Risks associated with short selling a stock are: The first three statements are correct

Default risk: potential unlimited losses when buying back the stock. The default risk is high as it increases when short selling is restricted sending the stock prices high.
Regulatory risk: a ban on short sales can create a surge in the stock price. This can cause the price in the stock price and the trader hasto incur huge losses to cover the position.
Dividend risk: the short seller is entitled to pay dividend if he shorts the stock on the record date.

The short selling is not considered as a risk with Systematic risk. The systematic risk will help when a trader short sells and any adverse news related to systematic risk will further decrease the stock price causing more profits.

Q B)

Leveraging the Portfolio: The correct Options are 2nd and 4th Options.

Increases the default risk by magnifying the standard deviation (risk) of your portfolio. Increasing the debt increases the risk involved in the portfolio as the default risk increases with leverage.
Increases systematic risk of the portfolio, that is the uncertainty inherent to the market as a whole and which cannot be diversified. The portfolio risk increases as the leverage increases and the systematic risk increases with change in macro or market conditions which effects the returns of the portfolio which cannot be diversified.

The first Option and third Option are incorrrect.

The increase in ROE is not consistent with negative returns as mentioned in the first Option.
The standard deviation of portfolio will increase as the leverage or debt which is borrowed is not risk free as these borrowed debt will have interest payments depending on interest rate at which the money is borrowed.