Short‐selling costs and asymmetric price response to economic shocks: A transaction cost explanation to price overshooting

Jose Ornelas and Pablo José Campos de Carvalho

International Journal of Finance & Economics, 2021, vol. 26, issue 2, 1745-1772

Abstract: We propose a model that combines performance‐based arbitrage, short‐sale constraints, and costly arbitrage. In the model, good earnings surprises trigger short‐covering causing price overshooting for highly shorted stocks. However, price overshooting is on average lower than short‐selling costs. Model predictions are empirically tested using Brazilian short‐selling data. We find empirical support for the short‐covering and overshooting phenomena. Furthermore, there is evidence that the intensity of overshooting is lower than the short‐selling borrowing fee, for both U.S. and Brazilian markets. Theoretical and empirical results suggest that arbitrageurs behave asymmetrically to good and bad earnings news.

Date: 2021
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https://doi.org/10.1002/ijfe.1876

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