Because concentrated investment portfolios generally arise from investments that have been held for a long time, they often have a low tax basis, much lower than their current market value. Less concentrated investment portfolios may also have a low tax basis, but are not as likely as a large, concentrated portfolio.
While it is true that an outright sale is generally a taxable event, this is true for both large, concentrated portfolios as well as smaller portfolios; this is not a distinguishing characteristic.
When selling a large, concentrated portfolio, the taxes are most likely going to be capital gains from the appreciation of the asset, not unearned income (e.g., interest); thus, although unearned income tax rates are generally higher than capital gains tax rates, they are not applicable here.
Taxes on a sale are likely to be high because tax rates on unearned income are generally higher than tax rates on capital gains.
Sale of the investment generally is a taxable event.
Capital gains taxes are likely to be quite high because of a low tax basis.
Statement 3 is correct: low average trading volume in a publicly traded stock will make dealers less inclined to enter into forward contracts, because of the potential difficulty of buying or selling sufficient shares at the expiration of the contract. In this case, because Wilde wants to enter into the short position, a dealer would have to enter into the long position; thus, the dealer would need assurance that he can sell the delivered shares when the contract expires.
1. Because shares of this stock are readily available for borrowing, dealers are less inclined to enter into the long position on a forward agreement; they would rather enter into the short position for which they could borrow shares to deliver.
2. With the risk–based margin lending system in place, Wilde can likely borrow only 50% of the value of the stock, even when it is fully hedged.
3. The average trading volume on Wilde's common stock is fairly low, making dealers less inclined to enter into forward contracts.
Which of the following three statements is MOST LIKELY correct?
Statement 1 is incorrect: when shares are readily available to borrow, dealers are more inclined to enter into short positions. They are able to borrow shares to deliver on those positions. They are also more inclined to enter into long positions. Dealers, in general, prefer to be neither net long nor net short, so the long positions will offset the short positions.
Statement 2 is incorrect: with a risk-based margin lending system, a fully hedged position can often be monetized to nearly 100% of its value. In a rule-based system, when the proceeds are to be used to buy more of the same stock, even having a fully-hedged portfolio will usually not allow for more than a 50% loan-to-value.
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