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.
Regulations allow market makers to short sell without borrowing stock, and the transactions of a major options market maker show that in most hard to borrow situations, it chooses not to borrow and instead fails to deliver stock to its buyers. Some of the value of failing passes through to option prices: when failing is cheaper than borrowing, the relation between borrowing costs and option prices is significantly weaker. The remaining value is profit to the market maker, and its ability to profit despite competition between market makers appears to result from a cost advantage of larger market makers.
The standard analysis of corporate governance assumes that shareholders vote in ratios that firms choose, such as one share-one vote. But, if the cost of unbundling and trading votes is sufficiently low, then shareholders choose the ratios. We document an active market for votes within the equity-loan market, where the average vote sells for zero. We hypothesize that asymmetric information motivates this trade and find support in the cross section. More trading occurs for higher-spread and worse-performing firms, especially when voting is close. Vote trading corresponds to support for shareholder proposals and opposition to management proposals. Similar results obtain in the U.K.
Using proprietary data on stock loan fees and quantities from a large institutional investor, we examine the link between the shorting market and stock prices. Employing a unique identication strategy, we isolate shifts in the supply and demand for shorting. We find that shorting demand is an important predictor of future stock returns: An increase in shorting demand leads to negative abnormal returns of 2.98% in the following month. Second, we show that our results are stronger in environments with less public information flow, suggesting that the shorting market is an important mechanism for private information revelation.
We present a model of asset valuation in which short-selling is achieved by searching for security lenders and by bargaining over the terms of the lending fee. If lendable securities are difficult to locate, then the price of the security is initially elevated, and expected to decline over time. This price decline is to be anticipated, for example, after an initial public offering (IPO), among other cases, and is increas- ing in the degree of heterogeneity of beliefs of investors about the likely future value of the security. The prospect of lending fees may push the initial price of a security above even the most optimistic buyer's valuation of the security's future dividends. A higher price can thus be obtained with some shorting than if shorting is disallowed.
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.
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