Shorting Stocks Recall that if the economy continues to be strong, Carson Compan

Question

Shorting Stocks

Recall that if the economy continues to be strong, Carson Company may need to increase its production capacity by about 50 percent over the next few years to satisfy demand. It would need financing to expand and accommodate the increase in production. Recall that the yield curve is currently upward sloping. Also recall that Carson is concerned about a possible slowing of the economy because of potential Fed actions to reduce inflation. It is also considering issuing stock or bonds to raise funds in the next year.

a. In some cases, a stock’s price is too high or too low because of asymmetric information (information known by the firm but not by investors). How can Carson attempt to minimize asymmetric information?

b. Carson Company is concerned that if it issues stock, its stock price over time could be adversely affected by certain institutional investors that take large short positions in a stock. When this happens, the stock’s price may be undervalued because of the pressure on the price caused by the large short positions. What can Carson do to counter major short positions taken by institutional investors if it really believes that its stock price should be higher? What is the potential risk involved in this strategy?

Explanation / Answer

a) Asymmetric information makes financial markets less efficient than they otherwise would be by allowing the party with superior information to take advantage of the party with inferior information. Where asymmetric information is high, resources are not put to their most highly valued uses, the person raising the resources.

In the question, Carson Company is the entity having superior information vis-a-vis the investors of its stock. If Carson wants to minimize asymmetric information, it has to be proactive in its approach to the problem.

The insider information that Carson has can be both positive and negative with respect to the impact that it has on the value of its stock in the market.

Carson can attempt to minimize information asymmetry through

Better corporate governance would involve having a very competent and active board, with a fair number of independent directors.

An active Board meets frequently and puts mechanism to evaluate performance of managers who are thus compelled to give targets and actuals against them, periodically. This would prevent holding back of information.

Frequent board meetings, will highlight the happenings and also the prospects. Some information asymmetry can be reduced thus.

b) Carson company can resort to buying back its own shares from the market if it has sufficient funds to do it. This may help in stabilizing the price. But this will have the effect of permanently draining its funds.

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