Short sale constraints and overpricing.

• Author: Lamont, Owen A.
• Position: Research Summaries

Short sale constraints--including various costs and risks of shorting, as well as legal and institutional restrictions--can allow stocks to be overpriced. If these impediments prevent investors from shorting certain stocks, then these stocks can be overpriced and thus have low future returns until the overpricing is corrected. By identifying stocks with particularly high short sale constraints, one identifies stocks with particularly low future returns.

Consider a stock whose fundamental value is $100 (that is, $100 would be the share price in a frictionless world). If it costs $1 to short the stock, then arbitrageurs cannot prevent the stock from rising to $101. If the $1 is a holding cost that must be paid every day that the short position is held, then selling the stock short becomes a gamble that the stock will fall by at least $1 a day. In such a market, a stock could be very overpriced, yet if there is no way for arbitrageurs to earn excess returns, the market is still in some sense efficient. If frictions are large, "efficient" prices may be far from frictionless prices.

Short Sale Constraints

To be able to sell a stock short, one must borrow it, and because borrowing shares is not done in a centralized market, finding shares sometimes can be difficult or impossible. In order to borrow shares, an investor needs to find an owner willing to lend them. These lenders receive a fee in the form of interest payments generated by the short-sale proceeds, minus any interest rebate that the lenders return to the borrowers. This rebate acts as a price that equilibrates supply and demand in the securities lending market. In extreme cases, the rebate can be negative, meaning investors who sell short have to make a daily payment to the lender for the right to borrow the stock (instead of receiving a daily payment from the lender as interest payments on the short sale proceeds). This rebate only partially equilibrates supply and demand, because the securities lending market is not a centralized market with a market-clearing price.

Once a short seller has initiated a position by borrowing stock, the borrowed stock may be recalled at any time by the lender. If the short seller is unable to find another lender, he is forced to close his position. This possibility leads to recall risk, one of many risks that short sellers face.

Generally, it is easy and cheap to borrow most large cap stocks, but it can be difficult to borrow stocks that are small, have low institutional ownership, or are in high demand for borrowing. In addition to the problems in the stock lending market, there are a variety of other short sale constraints. U.S. equity markets are not set up to make shorting easy. Regulations and procedures administered by the SEC, the Federal Reserve, the various stock exchanges, underwriters, and individual brokerage firms can...