Short-selling Costs Research Articles

The Term Structure of Short Selling Costs

I derive the term structure of short selling costs using the put-call parity relationship. The shape of the term structure is determined by informed investors’ beliefs of when negative information will enter the market and correct the overpricing. I show that forward costs predicts future costs and stock returns, consistent with the expectations hypothesis in the model. I also find that an upward sloping curve around the earnings announcement increases the probability of a negative earnings surprise by 6.7%, supporting the prediction that short selling costs are higher when negative information is more likely to arrive.

When the Options Market Disagrees

We construct a new measure of investor disagreement from signed equity options trading volumes. Options disagreement negatively predicts stock returns over various horizons. The high disagreement stock portfolio underperforms the low disagreement portfolio by approximately 5% per year after standard risk adjustments. Disagreement increases around both positive and negative news releases and its predictive power for stock returns does not depend on the news content. The level of disagreement and its predictive effect for stock returns increase with short-selling costs in the stock market. Consistent with agree to disagree theories, disagreement also positively predicts stock trading volume and volatility.

The Term Structure of Short Selling Costs

The Term Structure of Short Selling Costs

The Causal Effect of Limits to Arbitrage on Asset Pricing Anomalies

We examine the causal effect of limits to arbitrage on ten well-known asset pricing anomalies using Regulation SHO, which reduced the cost of short selling for a random set of pilot stocks, as a natural experiment. We find that the anomalies become substantially weaker on portfolios constructed with pilot stocks during the pilot period. Regulation SHO reduces the combined anomaly long-short portfolio returns by 77 basis points per month, a difference which survives risk adjustment with standard factor models. The effect comes only from the short legs of the anomaly portfolios.

SHO Time for Limits-to-Arbitrage and Asset Pricing Anomalies

We examine the causal effect of limits-to-arbitrage on ten well-known asset pricing anomalies using Regulation SHO, which reduces the cost of short selling for a random set of pilot stocks, as a natural experiment. We find that the anomalies become weaker on portfolios constructed with pilot stocks during the pilot period. The effect is both statistically and economically significant, and Regulation SHO reduces the anomaly long-short portfolio returns by as much as 77 basis points per month. We also show that the effect comes only from the short legs of the anomaly portfolios. The effect remains intact after risk-adjustment with the Fama-French three-factor model.

Limits of Arbitrage

We survey theoretical developments in the literature on the limits of arbitrage. This literature investigates how costs faced by arbitrageurs can prevent them from eliminating mispricings and providing liquidity to other investors. Research in this area is currently evolving into a broader agenda, emphasizing the role of financial institutions and agency frictions for asset prices. This research has the potential to explain so-called market anomalies and inform welfare and policy debates about asset markets. We begin with examples of demand shocks that generate mispricings, arguing that they can stem from behavioral or from institutional considerations. We next survey, and nest within a simple model, the following costs faced by arbitrageurs: (a) risk, both fundamental and nonfundamental; (b) short-selling costs; (c) leverage and margin constraints; and (d) constraints on equity capital. We finally discuss implications for welfare and policy and suggest directions for future research.

Arbitrage Risk and Stock Mispricing

AbstractIn this paper we examine the relation between equity mispricing and arbitrage risk and find that stocks with high arbitrage risk have higher estimated mispricing than stocks with low arbitrage risk. These results are not limited to high book-to-market or small capitalization stocks, and they are not sensitive to transaction and short-selling costs. In addition, they remain robust to alternative multifactor return generating specification models and mispricing measures. Overall, our empirical results are consistent with the conjecture that mispricing is a manifestation of the inability of arbitrageurs to hedge idiosyncratic risk, a major deterrent to arbitrage activity.

Limits of Arbitrage: The State of the Theory

We survey theoretical developments in the literature on the limits of arbitrage. This literature investigates how costs faced by arbitrageurs can prevent them from eliminating mispricings and providing liquidity to other investors. Research in this area is currently evolving into a broader agenda emphasizing the role of financial institutions and agency frictions for asset prices. This research has the potential to explain so-called market anomalies and inform welfare and policy debates about asset markets. We begin with examples of demand shocks that generate mispricings, arguing that they can stem from behavioral or from institutional considerations. We next survey, and nest within a simple model, the following costs faced by arbitrageurs: (i) risk, both fundamental and non-fundamental, (ii) short-selling costs, (iii) leverage and margin constraints, and (iv) constraints on equity capital. We finally discuss implications for welfare and policy, and suggest directions for future research.

Limits of Arbitrage: The State of the Theory

We survey theoretical developments in the literature on the limits of arbitrage. This literature investigates how costs faced by arbitrageurs can prevent them from eliminating mispricings and providing liquidity to other investors. Research in this area is currently evolving into a broader agenda emphasizing the role of financial institutions and agency frictions for asset prices. This research has the potential to explain so-called market anomalies and inform welfare and policy debates about asset markets. We begin with examples of demand shocks that generate mispricings, arguing that they can stem from behavioral or from institutional considerations. We next survey, and nest within a simple model, the following costs faced by arbitrageurs: (i) risk, both fundamental and non-fundamental, (ii) short-selling costs, (iii) leverage and margin constraints, and (iv) constraints on equity capital. We finally discuss implications for welfare and policy, and suggest directions for future research.

Implied Interest Rates in a Market with Frictions

There are many proxies for the short-term interest rate that are used in asset pricing. Yet, they behave differently, especially in periods of economic stress. Derivatives markets offer a unique laboratory to extract a short-term borrowing and lending rate available to all investors that is relatively free from liquidity and credit effects. Interestingly, implied interest rates do not resemble benchmark interest rates such as the three-month T-bill rate or LIBOR, but instead are much more volatile. I argue that the volatility in the implied short-term rate in futures and option markets is due to frictions arising from borrowing and short-selling costs. I derive an equilibrium model of the futures market where demand imbalances from traders affect the implied interest rate. In the model, the implied interest rate depends on the true risk-free rate and a latent demand factor. I estimate the model based on S&P 500 index futures using the Kalman filter. The risk-free rate that results from this estimation has time-series properties similar to Treasury and LIBOR rates, and anticipates interest rate changes. The spread between the risk-free and the T-bill rate correlates with liquidity proxies of the Treasury market, while the spread between LIBOR and the risk-free rate is related to economic distress. The latent demand factor is closely related to proxies for demand pressure in the futures market, such as large speculator positions as well as investor sentiment. The demand factor is positive (negative) when buying (selling) pressure is high and is difficult to borrow (to short-sell the underlying). I also find that demand imbalances are correlated across different indexes, for both futures and options.

Do Short Sellers Know More? Evidence from a Natural Experiment

Prior research has generally found that stocks with a high level of short interest perform poorly suggesting that short sellers have superior information. However, it is known that stock prices can affect corporate performance due to resource allocation: that is, a low stock price can negatively affect firm performance by denying the company capital or other resources needed for efficient operation (Subrahmanyam and Titman, 2001). Thus, it is not clear whether the excess returns to short sellers are a result of superior information or resource constraints imposed by a depressed stock price. We examine the informativeness of short sales following introduction of Rule 10b-21 that limited the ability of market participants to short sell prior to an SEO. Using recent research, we are able to categorize SEO-issuing firms into short sale constrained and short sale unconstrained stocks. We find that the underpricing of SEOs by firms that are short sale constrained increases after the rule. We believe that the higher cost of short selling reduces the level of short selling that makes the prices less informative and increases underpricing. On the other hand, there is no change in the level of underpricing for SEOs by firms where short sales are unconstrained. The underpricing does not decline which is consistent with absence of manipulative short selling. Thus, our evidence is consistent with the notion that short sellers possess superior information. Finally, we find that the post-issue underperformance occurs only for SEOs where short sales are constrained.

A note on execution costs for stock index futures: Information versus liquidity effects

This paper examines execution costs and the impact of trade size for stock index futures using price-volume transaction data from the London International Financial Futures and Options Exchange. Consistent with Subrahmanyam [Rev. Financ. Stud. 4 (1991) 17] we find that effective half spreads in the stock index futures market are small compared to stock markets, and that trades in stock index futures have only a small permanent price impact. This result is important as it helps to better understand the success of equity index products such as index futures and Exchange Traded Funds. We also find that there is no asymmetry in the post-trade price reaction between purchases and sales for stock index futures across various trade sizes. This result is consistent with the conjecture in Chan and Lakonishok [J. Financ. Econ. 33 (1993) 173] that the asymmetry surrounding block trades in stock markets is due to the high cost of short selling and the general reluctance of traders to short sell on stock markets.

Limited arbitrage and short sales restrictions: evidence from the options markets

We investigate empirically the well-known put–call parity no-arbitrage relation in the presence of short sales restrictions. Violations of put–call parity are asymmetric in the direction of short sales constraints, and their magnitudes are strongly related to the cost and difficulty of short selling. These violations are also related to both the maturity of the option and the level of valuations in the stock market, consistent with a behavioral finance theory of over-optimistic stock investors and market segmentation. Moreover, both the size of put–call parity violations and the cost of short selling are significant predictors of future returns for individual stocks.

How Much Does it Cost to Short Sale a Stock Index?

Options prices have been used extensively to assess the cost of short selling. The price of the underlying of the options implicit in the options prices is obtained using the Call-Put Parity and compared to the underlying price prevailing in the market. The disparities between the two prices are attributed to short sale constraints. This approach overlooks the fact that in the same way that options could be used to short sale the underlying, they could also be used to buy it. Therefore, Call-Put Parity disparities are related to both possibilities and thus standard measure of short sale costs implicit in options prices underestimated this cost. We suggest a new decomposition of the Call Put Parity disparities that we implement in the case of European options on a dividend protected stock index in a market without market makers. We estimate the cost of buying the underlying and the cost of short selling it through the option markets, the difference between the two costs being the incremental cost of short selling.

Stocks are special too: an analysis of the equity lending market

With a year of equity loans by a major lender, we measure the effect of actual short-selling costs and constraints on trading strategies that involve short-selling. We find the loans of initial public offering (IPOs), DotCom, large-cap, growth and low-momentum stocks to be cheap relative to the strategies’ documented profits and that investors who can short only stocks that are cheap and easy to borrow can enjoy at least some of the profits of unconstrained investors. Most IPOs are loaned on their first settlement days and throughout their first months, and the underperformance around lockup expiration is significant even for the IPOs that are cheap and easy to borrow. The effect of short-selling frictions appears strongest in merger arbitrage. Acquirers’ stock is expensive to borrow, especially when the acquirer is small, though the major influence on trading profits is not through expense but availability.

The Information Content of Short Interest: A Natural Experiment

An increase in the cost of short selling should increase the bearish information content of short interest announcements by driving relatively uninformed short sellers out of the market (Diamond and Verrecchia, 1987). We extend the Diamond and Verrecchia model to include short selling against the box and we test the extended model using a natural experiment based around the Tax Payer Relief Act of 1997 (TRA97). TRA97 made short selling more costly for those shorting against the box. Consistent with the implications of our extended model, this increase in short selling costs strengthened the negative relationship between short interest and subsequent stock performance post-TRA97.

EUROPEAN OPTION PRICING WITH GENERAL TRANSACTION COSTS AND SHORT-SELLING CONSTRAINTS

In this paper, we study the problem of European Option Pricing in a market with short-selling constraints and transaction costs having a very general form. We consider two types of proportional costs and a strictly positive fixed cost. We study the problem within the framework of the theory of stochastic impulse control. We show that determining the price of a European option involves calculating the value functions of two stochastic impulse control problems. We obtain explicit expressions for the quasi-variational inequalities satisfied by the value functions and derive the solution in the case where the parameters of the price processes are constants and the investor's utility function is linear. We use this result to obtain a price for a call option on the stock and prove that this price is a nontrivial lower bound on the hedging price of the call option in the presence of general transaction costs and short-selling constraints. We then consider the situation where the investor's utility function has a general form and characterize the value function as the pointwise limit of an increasing sequence of solutions to associated optimal stopping problems. We thereby devise a numerical procedure to calculate the option price in this general setting and implement the procedure to calculate the option price for the class of exponential utility functions. Finally, we carry out a qualitative investigation of the option prices for exponential and linear-power utility functions.