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Consider four different financial products you can invest in: 1. A 12-month certificate of deposit that earns 2% annual interest. 2. A par 1-year risk-free bond with a 2% annual coupon. 3. A par 1-year risky bond with a 3.5% annual coupon. 4. A $100 per share value stock that typically pays a 2–4% dividend annually. Question 4 Which of these can be sold short? State at least 2 reasons WHY you selected one or more securities OR why you did NOT select the other one/ones.

Question

Consider four different financial products you can invest in:

  1. A 12-month certificate of deposit that earns 2% annual interest.

  2. A par 1-year risk-free bond with a 2% annual coupon.

  3. A par 1-year risky bond with a 3.5% annual coupon.

  4. A $100 per share value stock that typically pays a 2–4% dividend annually.

Question 4 Which of these can be sold short? State at least 2 reasons WHY you selected one or more securities OR why you did NOT select the other one/ones.

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Solution

The financial products that can be sold short among the ones listed are the risky bond and the stock.

  1. Risky Bond: Bonds, including risky ones, can be sold short. Short selling a bond involves borrowing the bond and selling it with the expectation that it can be bought back at a lower price in the future. This is typically done when the investor believes that the bond's price will decrease in the future. The risky bond in this case has a higher coupon rate, which might suggest a higher risk and therefore a higher chance of price decrease.

  2. Stock: Stocks are the most commonly shorted security. An investor can borrow shares of stock to sell them with the expectation that the price will decrease and they can be bought back at a lower price. The stock in this case has a variable dividend rate, which might suggest volatility and therefore a potential for price decrease.

The certificate of deposit and the risk-free bond were not selected because these are typically stable, low-risk investments. The price of a risk-free bond, for example, is unlikely to decrease because the issuer is considered reliable and unlikely to default. Similarly, a certificate of deposit has a fixed interest rate and is held until maturity, so there is no opportunity to buy it back at a lower price.

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