The Short Rebate. What is it? Why would it ever be considered important? As most know, when a stock, or security, is purchased, cash is deducted from the account and the security is received. When the security is then sold, the security is deducted from the account and cash is received. When a stock, or other security, is sold short the above transactions happen in opposite order. Cash is received and the security is deducted from the account. However, as most will observe, the account started with cash and no security. So how is the security deducted from the account when the account never owned it? Simply, the account is now liable for the security. To offset this new liability, the account receives cash as an asset. The asset and liability created equal one another, thus creating no effect on the equity balance. So now there is an account with lots of cash and a liability. The initial cash deposit generates interest income. The cash generated from the short sale also generates interest income, but in a lesser amount. This lower interest rate is called the Short Rebate.

Why is this lower interest rate important? Finance is all about discounted net present values. A future value is discounted back to the present by a discount rate. The higher the discount rate, the lower the present value in relation to the future value. A lower discount rate causes a higher present value. The interest rate on the cash generated by a short sale is lower than cash owned by the investor. Normally an investor owns a stock because he believes that the future value will be in excess of the present value. In his analysis, he would discount that future expected value to a present value of today. The actual value would depend on the discount rate used. Here’s an example. In the future, the investor believes that a stock is worth $15 in ten years. At a discount rate of 4.1%, that same stock is worth $10 today. This means that if you bought the stock today for $10 and held it for ten years, you would receive an annual compounded return of 4.1%. If cash currently pays a 4.1% interest rate, then there would be no real economic difference in having cash in the bank or owning the stock. Both would accrue at a 4.1% return annually.

Where the short rebate matters is in its lower discount rate. If you short a stock and receive cash, but it only accrues interest at a 3.1% rate, your analysis as to your purchase price will be influenced by this lower discount rate. To continue the example above, if you discount a stock that has an expected future value of $15 in ten years into today’s value at a discount rate of 3.1%, you get a present value of $11.05. This signifies the buy price from the perspective of the short seller. This purchase price is higher than the price an investor would pay for the same security with the same expected price in the same time frame. The only difference is the lower discount rate. So what is the purchase price of a short seller? It’s the price a short seller would execute a buy order. In a short sale, first the stock is sold and then it is bought. The order of the normal buy-low and sell-high strategy is simply reversed.

What is important to remember is that the Short Rebate generates a higher buy price for a short seller than a typical investor. This will be explained further in our article titled, “The Four Prices of Every Stock”.