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Market-Based Solutions to Vital Economic Issues
Research
Mar 31, 2018

Short Selling Risk

Abstract

Short selling is a risky business. Short sellers must identify mispriced securities, borrow shares in the equity lending market, postcollateral, and pay a loan fee each day until the position closes. In addition to the standard risks that many traders face, such as margin calls and regulatory changes, short sellers also face the risk of loan recalls and the risk of changing loan fees. To date, the literature has viewed these risks as a static cost to short sellers, and empirical papers have shown that static impediments to short selling significantly affect asset prices and efficiency. The idea in the literature is simple: if short selling is costly, short sellers may be less likely to trade, and as a result prices may be biased or less efficient (e.g., Miller (1977), Diamond and Verrecchia (1987), Lamont and Thaler (2003)).

In this paper, we examine the costs of short selling from a different perspective. Specifically, we show that the dynamic risks associated with short selling result in significant limits to arbitrage. In particular, stocks with more short‐selling risk have lower future returns, less price efficiency, and less short selling.

 


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