CFA Level I · CFA Level I Exam · Hedge Funds
A hedge fund sells short shares of companies it believes are overvalued because of aggressive accounting. The fund holds almost no long positions and borrows the shares to sell them. A key risk specific to this strategy is most likely:
The key risk is a short squeeze. If prices rise or lenders recall borrowed shares, the fund may have to buy back stock at higher prices, magnifying losses. A short position's gain is capped at the price falling to zero, while the potential loss is unlimited.
- Aa short squeeze forcing the fund to buy back shares at higher pricesCorrect
- Blimited ability to use leverage
- Ca maximum possible gain that is unlimited
Explanation
Short sellers face potential unlimited losses and may be forced to cover when lenders recall shares or prices rise, a short squeeze. The maximum gain on a short is capped because the price cannot fall below zero. Short sellers can use leverage, so the second option is wrong.
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