Hi Jan Crawley; Let my take a swing at "explaining" why a bond holder would want to keep his short...
Right now, the bond holders have an in the money short, and a losing bond position. But the bond hasn't yet gone to zero, so they still have money available to lose on the bond. Consequently covering the short would leave them with a naked and dangerous (i.e. junk) bond position. Having an unhedged position like that is an unnecessary risk.
In addition, if they are a taxable entity, covering the short will leave them with a short term capital gain.
Now it is always possible that if they cover their short, that they could reshort at a higher price. But that would require a trader, not a hedger. Those of who actually try to make money trading know that sometimes you have to reenter your short at a lower price. The difference between the short at the higher price and the short at the lower price would be a loss (relative to their original position), just as if they had gone long in another account, (boxing the short) and then sold the long at a lower price.
So to ensure that they actually would improve their position by covering (or boxing) the short they would have to ensure that they could reshort at a higher price. Of course that is something that it is not possible to ensure. (The claims of the perfect traders not withstanding.)
If this explanation is insufficient, my apologies, I will fill out an example with the actual numbers, and the account values etc., at the end, showing the possible consequences of early coverage.
-- Carl |
