We use short selling data from Data Explorers from 2004 to 2012 to investigate the extent to which UK short sellers are informed investors, in accordance with Diamond and Verrecchia's (1987) hypothesis. Our results suggest that heavily-shorted stocks fail to consistently underperform their lightly-shorted counterparts. Short sellers' ability to predict firm performance is limited to firms that struggle for survival, such as firms about to enter bankruptcy or financial firms during the financial crisis. These results provide new evidence regarding the source of short-sellers' information and should be of interest to academics, financial regulators and market participants.
This study uses stock lending data from Data Explorers to assess the impact of short-selling constraints on the profitability of eight investment strategies. Returns from unconstrained long-short portfolios are compared with those from 'feasible' portfolios, constrained to short-selling only those shares that can be borrowed. We find that only a small percentage of the firms identified by Datastream for short-selling are available for lending, but our results suggest that differences in profitability between unconstrained and feasible strategies are statistically insignificant. We also find that the stock borrowing fee for the majority of the strategies is normally less than 1% per annum, showing that prior UK studies, which assumed that the short-selling fee is flat at 1.50% per annum, have overestimated such cost. Overall, these results indicate that stock loan unavailability and stock borrowing fees do not explain the persistence of returns from anomaly-exploiting quantitative investment strategies in the UK stock market.
The split capital investment trust crisis brought into focus the need for more reliable risk assessment techniques for shares in the sector. We discuss the strengths and weaknesses of traditional pricing and risk description measures for split capital investment trusts (e.g. gross redemption yield, cover, hurdle rates) and ways of making these more useful. We then examine the application of traditional option pricing techniques and discuss the problems encountered in this approach. Finally, we propose the use of stochastic modelling to deal more effectively with the complexities involved in both pricing shares and understanding their risks.
This study fills an important gap in the literature on loss realization aversion. It shows how a 'sophisticated' sub-set of investors, namely short-sellers, react to losses. Using daily data on stock lending, we estimate the average price at which short positions were initiated, thus permitting a study of short-sellers' responses to their own book losses. We find that shortsellers close their positions in response to losses and not simply in response to rising share prices. This is a key result and a distinction from findings in related research. We conclude that short-sellers do not exhibit an aversion to realizing losses, but instead accept their losses or 'mistakes' systematically. Stocks subject to short-covering in this manner do not subsequently under-perform the market, and so there is no evidence of an investment performance cost (other than transaction costs) associated with immediately covering short positions that fall to an accounting loss. As short-sellers are believed to play an important role in the setting of prices, the results of this study have implications for asset pricing and market efficiency. 3 IntroductionThere is no upper limit to the price at which a stock can trade. Consequently, there is no limit, in theory, to the amount of money that a short-seller can lose. This contrasts with the experience of long-only investors, where losses are limited to the amount of capital invested.Exposure to unlimited liability can have catastrophic consequences, including personal bankruptcy, and is thus an important consideration in risk management. In this paper, we use a relatively new commercial dataset to examine the response of short-sellers to losing positions. We find significant evidence that short-sellers cover their positions as losses grow.This is consistent with short-sellers' use of stop losses as a risk control mechanism. We relate our findings to the literature on loss realization aversion and the 'disposition effect', an observed regularity in many studies of investor behavior. Our evidence that short-sellers are not averse to realizing losses has important implications for asset pricing and market efficiency, providing a strong motivation for this research.The literature on behavioral finance describes a number of investor biases, or apparent divergences from rational behavior. Amongst these is the tendency for investors to hold on to their losing stocks too long and sell their winners too early. Shefrin and Statman (1985) call this the 'disposition effect'. They seek to explain it by combining 'prospect theory' (Kahneman and Tversky, 1979) with the notion of 'mental accounting' (Thaler, 1985).Prospect theory modifies expected utility theory in two ways. It suggests that individuals assess outcomes through the change they bring to their current situation (or other reference state) and not through their effect on overall wealth; and that utility functions are concave for gains and convex for losses (but steeper to attain overall risk aversion). Thus, losses (from a reference sta...
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