Short-sale Constraints Research Articles

The devil is in the detail? Investors’ mispricing of proxy voting outcomes on M&A deals

AbstractShareholders’ approval rates on M&A deals are informative because they are predictive of the acquirer's post‐merger operating performance. Since the passing of the deal is salient information while the specific approval rate is not, investors may misprice the detailed voting outcome due to their limited attention. We find that post‐merger abnormal stock returns are significantly higher for acquirers receiving higher approval rates: a one percentage point increase in the approval rate is associated with a 48 basis point increase in the market‐adjusted stock return in the year after the merger is completed. Consistent with mispricing, the voting outcome reliably predicts post‐merger earnings announcement returns and analyst forecast errors. What's more, the association between the voting outcome and post‐merger stock returns is stronger when investors’ attention to the voting outcome is distracted by same‐day earnings announcements, when the marginal investor is less likely to be sophisticated, and when investors have greater pre‐merger disagreement. Short sale constraints do not seem to explain our findings. Overall, our results suggest that detailed proxy voting outcomes are neglected by investors.

Mispricing, Short-Sale Constraints, and the Cross-Section of Option Returns

Motivated by the theory of demand-based option pricing in imperfect markets, we examine the relation between short-sale constraints and equity option returns, conditional on the level of mis-pricing in the underlying stock. We report a monotonic relation between various measures of short-sales constraints and delta-hedged returns of put options on overpriced stocks. This relation is robust to controls for firm attributes and limits to arbitrage proxies. Our findings suggest that while investors drive up the demand for these put options, dealers command a high premium as compensation for the increased market making risk. We do not find a robust relation for either put options on under-priced stocks or call options.

Offsetting Disagreement and Security Prices

We propose that investor beliefs frequently “cross” in the sense that an investor may like company A but dislike company B, whereas another investor may like company B but dislike company A. Such belief-crossing makes it almost impossible to construct a portfolio that is composed solely of every investor’s most favored companies. This causes the level of excitement for portfolios to be generally lower than the levels of excitement that individual companies generate among their most fervent supporters. Coupled with short-sale constraints, wherein prices are set by the most optimistic investors, this causes portfolios to trade at discounts. Utilizing several settings whereby the value of a portfolio and the values of the underlying components can be evaluated separately (e.g., closed-end funds), we present evidence supporting our proposition that, in financial markets, the “whole” is often less than the “sum of its parts.” This paper was accepted by Karl Diether, finance.

Loss aversion and market crashes

This study proposes a rational expectation equilibrium model of stock market crashes with information asymmetry and loss averse speculators. We obtain a state-dependent linear optimal trading strategy, which makes the equilibrium price tractable. The model predicts nonlinear market depth and the result that small shocks to fundamentals (e.g., supply or informational shocks) can cause abrupt price movements. We demonstrate that short-sale constraints intensify asset price collapses relative to upward movements. The model also generates contagion between uncorrelated assets. These results are consistent with the main puzzling features observed during market crashes, namely abrupt and asymmetric price movements that are not driven by major news events but coupled with a spillover effect between unrelated markets.

Margin Trading and Stock Idiosyncratic Volatility: Evidence from the Chinese Stock Market

In this paper, we find that the idiosyncratic volatility (IV) effect on expected returns exists and cannot be explained by other variables in the Chinese stock market. The Chinese stock market launched margin trading in March 2010. We therefore study the margin trading target and non-margin trading target stocks separately and find that the IV effect exists in both stock groups. The IV effect of the margin trading target stocks can be explained by the turnover ratio, whose mechanism shows that the short sale constraint hinders the expression of the seller’s heterogeneous beliefs. However, the IV effect of the non-margin trading target stocks cannot be interpreted by other variables. In comparison to margin trading target stocks, non-margin trading target stocks are more likely to have the lottery characteristics and their gambling behavior is more pronounced.

Mispricing firm-level productivity

Abstract This paper provides a mispricing-based explanation for the negative relation between firm-level productivity and stock returns. Investors appear to underprice unproductive firms and overprice productive firms. We find evidence consistent with the speculative overpricing of productive firms driven by investor sentiment and short sale constraints. Investors erroneously extrapolate past productivity growth and its associated operating performance and stock returns, despite their subsequent reversals. Such mispricing is perpetuated because of limits to arbitrage and is partially corrected around earnings announcements when investors are surprised by unexpected earnings news. Decomposition analysis indicates that extrapolative mispricing and limits to arbitrage explain most of the return predictability of firm-level productivity.

Short-Sales Constraints and the Diversification Puzzle

Disagreement about stock valuation, combined with short-sales constraints, can increase asset prices. We build a model showing that, so long as investor beliefs are not perfectly correlated, investors disagree less about the value of a conglomerate than about each of its individual divisions. This generates a conglomerate discount with disagreement and short-sales constraints being complementary in explaining its cross-sectional variation. We test these predictions empirically and find substantial support: conglomerates have lower differences of opinion and lower short-sales constraints than pure-play firms. Furthermore, greater differences of opinion and tighter short-sales constraints are significant predictors of valuation differences between conglomerates and pure plays. This paper was accepted by Karl Diether, finance.

Optimal Portfolio Choice Under Shadow Costs with Fixed Assets when Time-Horizon Is Uncertain

We analyze in this paper the problem of choosing the optimal portfolio for investors under uncertain exit random time. We consider the portfolio choice with fixed assets in the presence of information costs and short sales constraints. This context allows us to focus on the optimal portfolio choice with fixed assets. Investors aim to maximize the ratio between the wealth and the value of the fixed assets. We obtain the optimal portfolio choice strategy with fixed assets when the time horizon is a random exit time. Our results are new in the literature. We illustrate the main findings through some simulation results.

Analyst Forecast Dispersion and Market Return Predictability: Does Conditional Equity Premium Play a Role?

Prior studies found that analyst forecast dispersion predicts future market returns. Some prior studies attribute this predictability to the short-sale constraints in the market according to the overpricing theory. Using the U.S. data from 1981 to 2014, we find that the return predictive power of aggregate dispersion only exists prior to 2005. The investor sentiment index, as a proxy of short-sale constraints used by many studies, can only explain the dispersion effect prior to 2005. The investor sentiment index and other proxies such as institutional ownership and put options cannot explain the significant weakening of the dispersion effect after the global financial crisis. We argue that the dispersion-return relation is partly driven by the correlation between dispersion and conditional equity premium. Our evidence suggests that the short-sale constrained stocks do not experience a higher dispersion effect, which is contrary to what the overpricing theory predicts.

Effects of commodity exchange-traded note introductions: Adjustment for seasonality

This study investigates the impacts of the introductions of commodity exchange-traded notes on the corresponding underlying commodity futures markets around their issuance announcement and listing dates. Focusing on the Korean market, a leading and influential emerging market, we adopt an event study approach to analyze changes in futures returns and volatilities. Considering the potential cyclicality and seasonality of commodity futures dynamics, we use the Hodrick-Prescott filter to decompose the return processes into four separate components, that is, the trend, seasonal, cyclical, and irrational components, and we analyze only the irrational component as the abnormal excess return. We observe significant but temporary abnormal returns before issuance announcements, implying a hedging effect; significant negative abnormal returns after announcements of inverse products, indicating a short-sale constraint removal effect; and significant positive returns on the announcement dates of leveraged product portfolios, indicating a signaling effect. We also find that the volatility of the seasonal component significantly decreases after the introductions of leveraged products.

Information Percolation and Informed Short Selling: Evidence from Earnings Announcements

This study examines short selling in stocks of firms that reveal partial earnings-related information prior to their eventual earnings announcements (EA). By decomposing short selling into two components where the first corresponds to the final partial earnings disclosure and the second captures the subsequent incremental short selling until just before the EA, we estimate that the relative informativeness of shorting activity based on public partial versus private information accounts for approximately 80% and 20%, respectively, of the short selling-related decrease in the EA return. Importantly, the negative return predictability of short selling significantly increases the longer a firm implicitly delays its EA. Further, our evidence indicates time-varying short-sale constraints, ineffective following the release of partial information but rising markedly just prior to the EA. The overall findings support the proposition that short sellers are skilled investors who profit from both public partial and private information. The informativeness of short selling, however, depends critically on the efficacy of short-sale constraints.

The dynamics of short sales constraints and market quality: An experimental approach

We test the effect of short sale constraints on market quality in an experimental setting. Short sale constrained securities trade at a premium, which is often higher than the difference between the view of the most optimistic investor and the fundamental value. Opinion dispersion contributes to overpricing; this result is more pronounced at the time opinion dispersion is induced. As time progresses, traders update their valuations with information from trading. Consequently, opinion dispersion narrows and its effect on overpricing dissipates. Under short sale constraints, the speed of price adjustment is slower, as prices never fully converge to their fundamental values.

The R&D anomaly: Risk or mispricing?

We offer new evidence on the risk versus mispricing explanations for the R&D anomaly. Return covariance with a characteristic-based factor captures the cross-sectional return variation on R&D portfolios not explained by asset pricing models. This is consistent with both covariance risk and mispricing. Under the framework of the ICAPM, we find little economic justification that an R&D factor is a proxy for innovations to a state variable. The characteristic subsumes the factor loading in direct tests, providing support to the mispricing hypothesis. Investigating the mispricing explanation further, we reject the assertion that the R&D anomaly arises from the correction of stocks mispriced by investor sentiment. A natural experiment exploiting the pilot program under Regulation SHO shows no evidence that the anomaly persists due to limits to arbitrage in the form of short sale constraints.

Heterogeneous beliefs and return volatility around seasoned equity offerings

We investigate the dynamics of heterogeneous beliefs and link them to the volatility pattern throughout the seasoned equity offering (SEO) event window. In sync with a reduction in information asymmetry related to management information releases around the SEO event, belief heterogeneity declines. Moreover, heterogeneity in beliefs, proxied by either analyst- or institutional-trade-based measures, is a robust and salient determinant of SEO firm volatility, which provides an explanation for the volatility timing “puzzle” identified in the SEO market. Furthermore, the relation between heterogeneous beliefs and return volatility weakens as short sale constraints tighten, suggesting a potential causal link.

Is the Synthetic Stock Price Really Lower than the Actual Price?

Conventional wisdom suggests underpricing of synthetic stocks due to short-sale constraints and voting premiums. This study finds that such underpricing of mid quote point disappears once arbitrageurs face security borrowing costs. Rather, synthetic bid and ask prices predominantly contain actual bid and ask indicating that price takers face worse prices in the synthetic stock market regardless of the trade direction. Arbitrage opportunities with over priced synthetic stock is as likely as those with under priced synthetic stock but the former arbitrage opportunities are more persistent and more profitable. The difference between synthetic and actual price quotes is significantly affected by options market makers' hedging costs and investors' demand for leverage while adverse selection plays a limited role.

Earnings Surprises, Mispricing, and the Dispersion Anomaly

This study examines the role of expectations management in explaining why firms with high dispersion in analyst forecasts experience relatively low future stock returns. We first demonstrate that the negative relation between dispersion and returns is concentrated around earnings announcements and that this relation is stronger for firms more likely engaged in expectations management. Next, we find that firms with low analyst dispersion are significantly more likely to achieve positive earnings surprises, and provide new insights consistent with expectations management explaining this link. Most importantly, we find that the return predictability of dispersion is driven by the variation in dispersion that is explained by ex-ante measures of expectations management. These results are not a reflection of differences of opinion, firms' exposure to earnings announcement premia, and short-sale constraints. Overall, we conclude that the dispersion anomaly can be explained by investor mispricing of firms' participation in the earnings surprise game.

Worldwide short selling regulations and IPO underpricing

We study the impact of country-level short selling constraints on IPO underpricing. Examining 17,151 IPOs from 36 countries, we find that IPO underpricing tends to be greater in countries that ban short selling or security lending and in countries where short selling is not practiced. Non-positive first-day returns are more common in countries where short selling is allowed, security lending is allowed, and short selling is commonly practiced. Short selling constraints exacerbate the positive relation between investor sentiment and underpricing. Additional evidence suggests that higher quality information environments may partially alleviate the effects of short sale constraints on underpricing.

Alpha by Affiliation

Using novel data establishing hedge fund families, we show that changes in overlapping hedge fund family positions predict abnormal returns in U.S. stocks. A long-short portfolio of unanimous family entries and exits in overlapping positions earns an annualized alpha of 7.32%. Panel regressions and double-sorts provide evidence for a mispricing-based explanation as results are consistent with fund families facing binding short sale constraints to coordinated exits. The returns are larger for high information asymmetry stocks and suggest that hedge fund families coordinate on information, despite having no shared legal structure like mutual fund families.

Disagreement, Speculation and Management Forecasts

Prior research shows that disagreement leads to speculative trading and a speculative premium in stock prices. We examine how managers respond to this speculative premium. Using exogenous variation in speculative trading due to the reconstitution of the Russell 1000/2000 indices, we find that speculative trading reduces the frequency, likelihood, and precision of management forecasts. Consistent with theory, this relationship is significantly stronger when short sale constraints are more binding, and when managers have stronger equity-based incentives. We also find that managers sell equity to benefit from the speculative premium. In summary, our results suggest that managers issue forecasts opportunistically in response to speculative trading: they either keep silent, or issue fewer and more ambiguous forecasts to prolong disagreement among investors and the speculative premium.

Mean-Preserving Unawareness in General Equilibrium

I model an incomplete markets economy where unaware agents do not perceive all states of nature, so unintended default can occur when asset returns differ from what was perceived. First, equilibrium is shown to exist. The First Fundamental Welfare Theorem fails because of default and pecuniary inefficiencies, but the Second Fundamental Welfare Theorem holds for economies with no aggregate risk. Welfare is shown to not necessarily be monotonic in discovery, or the increasing of awareness. Four potential policies are compared based on their ability to implement Pareto optimal allocations: short sale constraints, lump sum transfers, financial innovation, and financial education.