Chartered Financial Analyst (CFA) Practice Exam Level 2

What happens to the long side's price if the benefits received by the short side decrease?

1. The price increases

2. The price decreases

3. The price remains the same

4. It becomes unpredictable

The correct answer is: The price increases

When the benefits received by the short side of a transaction decrease, it leads to a greater imbalance in the market dynamics that favor the long side. This is because the short side, typically bearing the risks and responsibilities associated with the position, would find itself in a less advantageous situation if the benefits or incentives associated with shorting a security diminish. As a result, the scarcity of short positions due to these decreasing benefits can increase demand for the long side, as fewer investors may be willing to take on a short position. Consequently, as demand for the long positions rises while the supply remains the same or decreases, the price for the long side would naturally increase. This scenario illustrates fundamental supply and demand principles—if one side of the market (the short side) becomes less appealing, the opposite side (the long side) will see heightened interest, pushing its price upward.