Short Interest and Aggregate Volatility Risk

Abstract

We find that stocks with high relative short interest (RSI) beat the CAPM when expected aggregate volatility increases, which explains their negative CAPM alphas. The reason is that stocks with high RSI have high levels of firm-specific uncertainty and abundant real options. When aggregate volatility increases in recessions, firm-specific uncertainty also does. All else equal, the increase in uncertainty makes real options less sensitive to the value of the underlying asset and, therefore, less risky. Also, all else equal, higher uncertainty means higher value of real options. Consistent with this argument, we find that high RSI firms earn negative CAPM alphas only if these firms have high uncertainty or abundant real options. The two-factor ICAPM with the aggregate volatility risk factor explains the negative alphas of high RSI firms and the more negative alphas of high RSI firms with high levels of uncertainty or real options.