Question

Assume that the expected return of the U.S. stock market is 10% and the volatility is 20%. Suppose that, instead of buying stocks, I choose to short-sell stocks all the time. What would be the expected return and volatility of my strategy?

I know the answer to this question was solved already but it is still really confusing. Can someone else try to explain everything a little more clearly. Thanks

Answer 1

As per CAPM,expected return is ;

=Risk free rate+beta*(market rate of return-risk free rate)

In case of short sell,an investor borrow a stock,sells the stock,and then buys the stock from the market to return it to the lender.He belives that the stock he sell will drop in price.

Volatility is considered as the risk(beta) associated with the company.Short traders are also expecting the similar rate of return like an other investor.Thus for Calculation of expected return we have;

Beta=20% or 0.20

Market rate of return=10%

Risk free rate=5%(assumed)

Expected return=5%+0.20*(10%-5%)

=6%

Hence,rate of return expected by short trader is 6%.