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

Abstract

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. Disciplines Finance | Finance and Financial ManagementThis journal article is available at ScholarlyCommonsWith a year of equity loans by a major lender, we measure the effect of actual shortselling costs and constraints on trading strategies that involve short-selling. We find that wholesale costs of equity loans for shorting IPO's, DotComs, large-cap, growth and lowmomentum stocks are small relative to the documented benefit, and that investors who can short only stocks that are cheap and easy to borrow can closely track the returns of unconstrained investors. Most IPO's are loaned on their first settlement days and throughout their first months, and the underperformance around lockup expiration is significant even for the subset of stocks that are cheap and easy to borrow. The effect of short-selling frictions appears strongest with merger arbitrage. Acquirers' stock is expensive to borrow, especially acquirers with small market capitalizations. The additional cost paid in merger arbitrage positions does not significantly affect profits, but the shortage of available issues reduces profits by more than half.

Short selling in initial public offerings☆

“…Dorn (2009), Aussenegg, Pichler, andStomper (2006) and Cornelli, Goldreich, and Ljungqvist (2006) examine pre-IPO markets that allow short selling and still find evidence that investor divergence of opinion is correlated with underpricing in the trading of IPOs. 12 Direct evidence on the costs of short selling is presented by D'Avolio (2002) and Geczy, Musto, and Reed (2002). In particular, the Geczy, Musto, and Reed (2002) results indicate that although IPOs are initially more expensive to short in the first month of trading, the overall cost of shorting is fairly small at around 3% at issuance and this value declines to approximately 1.5% per year.…”

“…12 Direct evidence on the costs of short selling is presented by D'Avolio (2002) and Geczy, Musto, and Reed (2002). In particular, the Geczy, Musto, and Reed (2002) results indicate that although IPOs are initially more expensive to short in the first month of trading, the overall cost of shorting is fairly small at around 3% at issuance and this value declines to approximately 1.5% per year. They also conclude, contrary to Ofek and Richardson (2003), that the cost of short selling around lockups does not appear to be an impediment.…”

“…Both Geczy, Musto, andReed (2002) andD'Avolio (2002) find that shares of most IPOs are available for borrowing as soon as the first settlement day. We add to their findings by presenting evidence on the magnitude and timing of short selling.…”

Can Short-sellers Predict Returns? Daily Evidence

“…1 Jones and Lamont (2002), Geczy, Musto, and Reed (2002), Ofek and Richardson (2003), Reed (2002), Ofek, Richardson, and Whitelaw (2003), Mitchell, Pulvino, and Stafford (2002)) to investigate if short-sale constraints contribute to short-term over-reaction in stock prices, and if short sellers are informed. The general conclusion reached by this literature is that short-sale costs are higher and short-sale constraints are more binding among stocks with low market capitalization and stocks with low institutional ownership.…”

Bubbles, Crises, and Heterogeneous Beliefs

“…D'Avolio (2002) and Geczy, Musto, and Reed (2002) empirically analyze the market for borrowing stocks. They find that while it is easy to borrow most stocks at modest fees, the fees can become economically significant when the interest in short-selling becomes high relative to shares available due to either divergence of opinion among investors or special events such as merger announcements that make short-selling profitable.…”