Short Interest and Tobin's Q Ratios: Dynamic Response and Causality

Abstract

This study investigates the dynamic response of the change in short interest ratio in the equity market (SIR) to the change in aggregate Tobin’s q ratio (∆TBQ). Looking at the quarterly data from 1951Q4 to 2012Q4, the VAR results show that SIR drops following the shock to ∆TBQ after one quarter. The causality test results also confirm that the ∆TBQ causes the SIR to decrease. The variance decomposition analysis shows that the ∆TBQ forecasts ∆SIR about 7.26% at the 3-quarter horizon and around 7.51% at the 6-quarter horizon. The findings imply that when firms in the economy are generating more values or have more investment opportunities, investors, on average, are more optimistic and ride along the momentum thus significantly reducing their short-selling trade activity in the equity market.