Shares in Springfield Nuclear Power Corp. currently sell for $25. You believe that the shares will be worth $30 in one year, and this implies that the return you expect on these shares is 20% (the company pays no dividends).
a. If you invest $10,000 by purchasing 400 shares, what the expected value of your holdings next year?
b. Now suppose that you buy 400 shares of SNP, but you finance this purchase with $5,000 of your own funds and $5,000 that you raise by selling short 100 shares of Nader Insurance Inc. Nader Insurance shares currently sell for $50, but next year you expect them to be worth $52. This implies an expected return of 4%. If both stocks perform as you expect, how much money will you have at the end of the year after you repurchase 100 Nader shares at the market price and return them to your broker? What rate of return on your $5,000 investment does this represent?
c. Suppose you buy 400 shares of SNP and finance them as described in part (b). However, at the end of the year SNP stock is worth $31. What was the percentage increase in SNP stock? What is the rate of return on your portfolio (again, after you repurchase Nader shares and return them to your broker)?
d. Finally, assume that at the end of one year, SNP shares have fallen to $24. What was the rate of return on SNP stock for the year? What is the rate of return on your portfolio?
e. What is the general lesson illustrated here? What is the impact of short selling on the expected return and risk of your portfolio?