Bridge over ocean
1 January 1977 Financial Analysts Journal Volume 33, Issue 1

Short Selling and Financial Arbitrage

  1. Edward F. Renshaw

The return on the market as a whole is positive about twice as often as it is negative. Why should an investor sell the market short if he can’t distinguish between bull and bear markets in advance? In almost any market situation, however, he can reduce portfolio variance and increase expected return by selling short individual assets. For example, an investor who is unable to forecast the performance of an industry, but able to anticipate the relative performance of individual companies, can use a hedged position within that industry to improve his portfolio performance.

Short selling will generally be more effective, the more positive the correlation between the asset sold short and the asset purchased. An example is classical arbitrage, where two assets are convertible at some future time at a predetermined exchange ratio. Although a detailed understanding of portfolio theory may not be essential to obtaining reasonably good results in classical arbitrage, it can be critical when the correlation is imperfect; faulty hedging can lead to instant disaster.

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