After an analysis of Lion/Bear, Inc., Karl O%u2019Grady has concluded that the f

Question

After an analysis of Lion/Bear, Inc., Karl O%u2019Grady has concluded that the firm will face financial difficulty within a year. The stock is currently selling for $5 and O%u2019Grady wants to sell it short. His broker is willing to execute the transaction but only if O%u2019Grady puts up cash as collateral equal to the amount of the short sale. If O%u2019Grady does sell the stock short, what is the percentage return he loses if the price of the stock rises to $7? What would be the percentage return if the firm went bankrupt and folded?

Please include calcuations whereas I am struggling with this one! Thank you!!

Explanation / Answer

If Grady sells the stock short and the price of the stock rises to $7, then technically there should be a loss to him, a loss of $2 or % return of (5-7)/7 * 100 = -28.57%...........But in case he defaults on his obligation, then there will be no profit no loss to him as the amount that he put as collateral is same as the amount he recieved as a result of short selling the stock. SO the % return in this case would be 0%..................................................................If the firm went Bankrupt and folded, there would be no stocks of the firm again he would have a no profit no loss situation as he gained $5 by short selling the stock which is also the amount that he kept as collateral with the broker.

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