Short Sales Research Articles

The disciplinary effects of short sales on controlling shareholders

Abstract Although the literature (Massa et al., 2011; Karpoff and Lu, 2010) demonstrates the disciplinary effects of short sales on managers, no study has analyzed how short sales can mitigate the agency costs of controlling large shareholders. Using the introduction of short sales in China as an exogenous event, we show that short sales also serve as an effective mechanism in curbing expropriation by the controlling large shareholder. The disciplinary effect is more pronounced for firms with higher ownership concentration and bankruptcy risk, and it is muted when alternative governance mechanisms are in place. Our paper provides new insights into the effects of short sales in the corporate governance domain, specifically in mitigating the agency costs between controlling and minority shareholders.

Capital Asset Pricing Model Without Borrowing or Short Sales

Using a new utility framework, the author constructs a capital asset pricing model (CAPM) without borrowing or short sales. According to the new utility framework, borrowing at the risk-free rate and short sales of the zero-beta portfolio cause a decline in risk tolerance. This rules-out a linear investment frontier. Instead, the frontier is described as an upward-sloping, convex curve that consists of many efficient portfolios. In the absence of short sales, the linear regression between asset returns and asset betas holds only in special cases. Also, the intercept of the regression is unique to each efficient portfolio. Using the proposed model, the author explains empirical violations of traditional CAPMs including the Equity Premium Puzzle and the predictive power of non-beta factors such as market size, P/E and book-to-market ratios.

Are short-sales constraints binding when there is a centralized lendable securities market? Evidence from Japan

This study examines the significance of short-sales constraints in the presence of a centralized lendable securities market in Japan. We find evidence that a centralized lendable securities market experiences lower short sales constraints. The cost of borrowing stock is found to be lower in Japan's centralized lendable securities market compared with a non-centralized lendable securities market. We also find evidence that recall risk is lower in a centralized lendable securities market. Additionally, there is evidence that stocks are not systematically overvalued in the presence of the centralized lendable securities market. These results are robust when alternative measures of short-sales constraints are considered.

How Did Short Sale Ban Affect German Capital Market Risk?

The problem of short sale is a popular issue of stock trading and efficiency of pricing. Most regulatory authorities around the world adopted in the period 2007–2010 ad hoc bans on short selling. This paper provides an examination of an impact of the short sale regulation on the German capital market during crisis period 2008–2010. The purpose is to identify effects of the short sale regulation on level of systematic risk on German capital market and to investigate the discovery of stock prices of German blue chips at the period from May 2007 to April 2011 and three sub periods which demonstrate different regulatory approach to naked short sale regulation. The results suggest that short sale ban affects the level of systematic risk in the German market and prolongs a price reaction on new information. Further, short sale ban limits activities of investors with bearish view. After adoption of short sale ban the level of systematic risk increases and not only banned stocks are affected by the regulation. Finally, at the analyzed period the problem of negative information corporation in stock prices has arisen. Thereafter, the short sale ban is lifted the level of systematic risk decrease and there are not significant differences for banned and not banned stocks. Further, the price efficiency measured by autocorrelation also decreased after ban is lifted.

Margins on short sales and equilibrium price indeterminacy

This paper studies the price and trading impact of margin rules for short selling within the context of Markowitz (1952). Our analysis is based on a newly obtained analytic solution for optimal portfolio holding under arbitrary margin rules. It is shown that heterogeneity in margins may have pricing effects and lead to price indeterminacy, particularly in the presence of derivative trading. Existence of equilibrium, along with a characterization theorem on the equilibrium outcome, is proved when investors have heterogeneous beliefs and different margins. Partial equilibrium analyses were carried out for the special case where investors agree on the volatility structure, but may hold different beliefs on expected payoffs. Upward deviations from the CAPM were discovered, extending Miller (1977)’s prediction to a multi-asset context.

A Simple optimality-based no-bubble theorem for deterministic sequential economies with strictly monotone preferences

We establish a simple no-bubble theorem that applies to a wide range of deterministic sequential economies with infinitely lived agents. In particular, we show that asset bubbles never arise if at least one agent can reduce his asset holdings permanently from some period onward. Our no-bubble theorem is based on the optimal behavior of a single agent, requiring virtually no assumption beyond the strict monotonicity of preferences. The theorem is a substantial generalization of Kocherlakota’s (1992) result on asset bubbles and short sales constraints.

A CAPM WITH TRADING CONSTRAINTS AND PRICE BUBBLES

This paper derives an equilibrium capital asset pricing model (CAPM) in a market with trading constraints and asset price bubbles. The asset price processes are general semimartingales including Markov jump-diffusion processes as special cases, and the trading constraints considered include short sale restrictions, borrowing constraints, and margin requirements, among others. We derive a generalized intertertemporal CAPM and consumption CAPM for these markets. The implications for empirical testing are that additional systematic risk factors will exist in a market with trading constraints and price bubbles as contrasted with an otherwise equivalent unconstrained market with no price bubbles.

Impact of Short Selling on Volatility of Individual Stocks and Aggregate Market: Empirical Evidence from China.

This paper explored the linkage between short selling and market stabilization. While financial and economic theory advocates the positive role played by short sellers for market stabilization, short sellers are frequently blamed for causing market decline and increasing the panic in falling markets. China's regulators allowed short selling in 2010 and this reform provided us an interesting data set to check whether short sellers destabilize the market or play a positive role. By using asymmetric TGARCH model on daily return data of Shanghai Stock Exchange 50 index from January 5, 2007 to June 11, 2012, and taking into account Day-of-the-Week effect, financial crisis and regional and international spillovers, we found robust evidence that short sale trading reduces the volatility and stabilizes the market. Our findings have implications for China's regulators in policy making as well investors in the Chinese stock market in portfolio development.

Are Shorts Equally Informed? A Global Perspective

Using a daily sample of 25 countries from 2006 to 2010, we examine whether information from shorts can significantly predict future stock returns across different countries. We construct seven shorting measures using past shorting transactions, and fees information in the lending market. The majority of our shorting measures significantly predict future stock returns. Interestingly, the relative importance of these variables varies substantially across countries. We explain the cross-country differences with variations in regulations on short selling, market quality and country development measures. The recent naked short sale bans strengthen the informativeness of shorting. The presence of a centralized stock lending market and low liquidity weaken the return predictability of short selling. In addition, higher country GDP per-capita, as well as country market openness, enhances short sales’ informativeness.

Short Sales Mechanism, Litigation Risk and Audit Fees

This paper examines how the short sales mechanism affects firms' audit fees through the changes in litigation risk, based on the natural experiment of securities margin trading in China. It comes to the conclusions that the introduction of short sales mechanism reinforces the pressure of the fall in stock prices and strengthens the incentive of investors to search bad news of companies, leading to the increase in audit litigation risk of companies and higher audit fees required by accounting firms. Further analysis suggests that the short sales mechanism plays a more obvious role in the increase in audit fees of state-owned enterprises, owing to poor information disclosure environment in state-owned enterprises; due to stronger compensation capacities of Big Four, the short sales mechanism significantly results in the rise in audit fees of Big Four; as for enterprises located in areas with poorer legal environment, because the management has the motivations to hide bad news, their audit fees significantly increase because of the existence of the short sales mechanism.

Large-Scale Portfolio Allocation Under Transaction Costs and Model Uncertainty

We theoretically and empirically study large-scale portfolio allocation problems when transaction costs are taken into account in the optimization problem. We show that transaction costs act on the one hand as a turnover penalization and on the other hand as a regularization, which shrinks the covariance matrix. As an empirical framework, we propose a flexible econometric setting for portfolio optimization under transaction costs, which incorporates parameter uncertainty and combines predictive distributions of individual models using optimal prediction pooling. We consider predictive distributions resulting from highfrequency based covariance matrix estimates, daily stochastic volatility factor models and regularized rolling window covariance estimates, among others. Using data capturing several hundred Nasdaq stocks over more than 10 years, we illustrate that transaction cost regularization (even to small extent) is crucial in order to produce allocations with positive Sharpe ratios. We moreover show that performance differences between individual models decline when transaction costs are considered. Nevertheless, it turns out that adaptive mixtures based on high-frequency and low-frequency information yield the highest performance. Portfolio bootstrap reveals that naive 1=N-allocations and global minimum variance allocations (with and without short sales constraints) are significantly outperformed in terms of Sharpe ratios and utility gains.

The Monte dei Paschi affaire: distressed banks and the European regulation on short selling

The European Regulation on short selling (SSR) has been applied to restrict hedge funds from short selling the stock of Monte dei Paschi di Siena (MPS) as part of a distressed securities strategy. In the MPS case, a distressed securities strategy was carried out based on short selling, despite the adoption of a temporary ban on short selling by means of purchasing put options from a market maker. Article 23 of the SSR provides that the national competent authorities (NCAs) may prohibit or restrict the execution of short sales in the event of a decrease in price by a given percentage during a single day’s trading for a given financial instrument. The temporary ban on short selling adopted by the NCAs or the ESMA under the SSR can be circumvented by means of an indirect use of the market making exemption. When adopting the ban and conceding the market making exemption, we take the view that the NCAs and the ESMA should require market makers to prohibit investors from increasing their net short positions in the focal stock.

Healthcare marketing: Does marketing strategy address essential markets?

Participants in the study were major pharmaceutical companies, it was striking to note that the prevalence of a short sales rather than strategic marketing orientation at senior management and Board level. Symptomatic of this result was the general finding that a businesses's intended overall strategy was rarely translated into expected results. A critical reason emerged – a disconnection between key stakeholders in the communication of strategy. While many businesses had internal communication functions, there was a lack of clarity about organisational fit and role. The findings suggested that businesses should embrace a broader marketing strategy and more specifically apply ‘marketing like activities’ or tried and tested marketing tools to their internal stakeholder market so as to mirror communication to external markets. The recommendations suggest a working model as a basis for a ‘trialogue’ between internal stakeholders, strategic leadership and external markets in the context of a business's strategy.

Short Interest, Bearish Option Trades, and Short-Sale Constraints

Recent research has focused on the information content of short sales. In the plain vanilla capital asset pricing model, shorting a stock one thinks is priced too high is symmetrical with buying a stock one thinks is undervalued. However, there are several impediments to short selling in the real world that break the symmetry. A classic argument by Miller holds that when investors have heterogeneous beliefs about a stock but the market constrains short sales by the pessimists, the optimists will bid the price up too high and future returns will underperform. Because shorting is not actually prohibited, the question arises as to whether a stock with a relatively high level of short interest has a higher than average degree of latent pessimism (bad news for future returns) or, alternatively, is subject to no more negative beliefs than other stocks (no news) but has lower than average costs to short selling. Furthermore, the introduction of options trading creates alternative ways for investors with negative information to trade on their views by buying puts or writing calls. Du presents strong evidence supporting Miller’s argument and shows that high relative short interest is a signal of overpricing; high dispersion of opinion (as shown in earnings forecasts) and high short interest both are associated with overpricing and reinforce each other, and bearish option trades are a substitute for short sales.

Short Selling and the Subsequent Performance of Initial Public Offerings

This paper examines short sales transaction volumes on the first trading day of 610 initial public offerings (IPOs) from 2011 to 2015. The tests provide evidence of informed trading immediately at the IPO. Results reveal that short selling volume on the first trading day of the IPO is significantly negatively linked to subsequent stock returns and accounting performance. Heavily-shorted IPOs underperform lightly-shorted IPOs by a risk-adjusted average of 22.68% annualized return. Heavily-shorted IPOs have the highest probability of analyst downgrades within the first year after the IPO. Short selling is higher in hot IPOs with higher demand and higher first-day return. These stocks are overpriced at the end of the first trading day, implying that short sellers are sophisticated investors taking advantage of the overpricing. Overall, the results indicate that short sellers are important contributors to efficient stock prices.

Comparing large-sample maximum Sharpe ratios and incremental variable testing

Most existing results on the distribution of the maximum Sharpe ratio depend on the assumption of multivariate normal return distributions. We use recent results from the literature to provide an analytical representation of the distribution of the difference between two maximum Sharpe ratios for much less restrictive distributional assumptions, both with and without short sales. Knowing the distribution of the difference enables us to test ex ante whether or not the inclusion of additional variables leads to a significant improvement in the maximum Sharpe ratio. In addition, we characterize the optimal long-only solution and provide conditions for global optimality.

Shortability and asset pricing model: Evidence from the Hong Kong stock market

Abstract This study explores how the violation of free short selling assumption affects the performance of CAPM and the Fama-French three-factor model, as existing studies show that short-sales constraints affect asset pricing of the stocks. Using data from the Hong Kong Stock Market which has unique regulations on short selling, we conduct both time-series and cross-sectional regression analyses to evaluate the performance of the two models under the short-sales-constraints and the no-constraints market environment. The two models perform much worse in the former environment than in the latter, indicating a significant impact of the short sales constraints on the explanatory power of the models. We then augment the two models with a shortability-mimicking factor. Our results show that the factor has a significant power in explaining both time-series and cross-sectional variation in the size-B/M portfolio returns. The addition of the factor to the two models considerably increases their overall performance.

Idiosyncratic tail risk and expected stock returns: Evidence from the Chinese stock markets

We estimate idiosyncratic tail risk according to the extreme value theory. Both portfolio analyses and cross-sectional regressions suggest a significant negative relationship between the idiosyncratic tail risk and the expected returns in Chinese stock markets after controlling for other risk measures including size, book-to-market ratio, beta, momentum, short-term reversals, liquidity, idiosyncratic volatility, downside beta, co-skewness, co-kurtosis, idiosyncratic skewness, idiosyncratic kurtosis, value at risk and maximum daily returns. Turnover explains the negative effect of the idiosyncratic tail risk in Chinese stock markets where individual investors dominate the markets and short sales are constrained.

Optimal trade execution under endogenous pressure to liquidate: Theory and numerical solutions

We study optimal liquidation of a trading position (so-called block order or meta-order) in a market with a linear temporary price impact (Kyle, 1985). We endogenize the pressure to liquidate by introducing a downward drift in the unaffected asset price while simultaneously ruling out short sales. In this setting the liquidation time horizon becomes a stopping time determined endogenously, as part of the optimal strategy. We find that the optimal liquidation strategy is consistent with the square-root law which states that the average price impact per share is proportional to the square root of the size of the meta-order (Bershova & Rakhlin,2013; Farmer et al., 2013; Donier et al., 2015; Tóth (2016).Mathematically, the Hamilton–Jacobi–Bellman equation of our optimization leads to a severely singular and numerically unstable ordinary differential equation initial value problem. We provide careful analysis of related singular mixed boundary value problems and devise a numerically stable computation strategy by re-introducing time dimension into an otherwise time-homogeneous task.

The Short Selling Regulation in the EU: Assessing the Authorization Granted for ESMA to Prohibit Short Selling

The paper discusses the renewed short selling regulation (Regulation (EU) No 236/2012) in the European Union. The focus is on the provisions that deal with prohibiting short selling in exceptional market circumstances. The Regulation further enforces certain obligations to report and disclose short positions. It is concluded that banning short selling is not an effective tool to contain extreme price volatility. The difference-in-differences regression and repeated measures GLM were used to test whether short selling bans were successful in containing volatility of those Spanish and Italian stocks that were subject to two back-to-back prohibitions during the years 2011-2013. The results are consistent with the majority of previous research, suggesting that the effectiveness of short sale constraints in reducing volatility is limited at best. Furthermore, there are evidence of counterproductive effects: constraints on short selling may actually increase volatility as well as deteriorate liquidity. However, based on theory and previous studies, reporting and disclosure requirements shall be favored provided they improve market efficiency as well as supervisory work of regulatory bodies.This paper discusses the renewed short selling regulation (Regulation (EU) No 236/2012) in the European Union. The focus is on the provisions that deal with prohibiting short selling in exceptional market circumstances. The Regulation further enforces certain obligations to report and disclose short positions. It is concluded that banning short selling is not an effective tool to contain extreme price volatility. The difference-in-differences regression and repeated measures GLM were used to test whether short selling bans were successful in containing volatility of those Spanish and Italian stocks that were subject to two back-to-back prohibitions during the years 2011-2013. The results are consistent with the majority of previous research, suggesting that the effectiveness of short sale constraints in reducing volatility is limited at best. Furthermore, there are evidence of counterproductive effects: constraints on short selling may actually increase volatility as well as deteriorate liquidity. However, based on theory and previous studies, reporting and disclosure requirements shall be favored provided they improve market efficiency as well as supervisory work of regulatory bodies. <w:LsdException Locked="fal