SHORT SELLING WITH MARGIN RISK AND RECALL RISK

Kristoffer Glover and Hardy Hulley ()
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Hardy Hulley: Finance Discipline Group, University of Technology Sydney, P. O. Box 123, Broadway, NSW 2007, Australia

International Journal of Theoretical and Applied Finance (IJTAF), 2022, vol. 25, issue 02, 1-33

Abstract: To investigate the effect of short-selling constraints on investor behavior, we formulate an optimal stopping model in which the decision to cover a short position is affected by two short sale-specific frictions — margin risk and recall risk. Margin risk is introduced by assuming that a short seller is forced to close out their position involuntarily if they cannot fund margin calls (since short sales are collateralized transactions). Recall risk is introduced by permitting the lender to recall borrowed stock at any time, once again triggering an involuntary close-out. Examining the effect of these frictions on the optimal close-out strategy and associated value function, we finding that the optimal behavior can be qualitatively different in their presence. Moreover, these frictions lead to a substantial loss in value, relative to the first-best situation without them (a reduction of approximately 17% for our conservative base-case parameters). This significant effect has important implications for many familiar no-arbitrage identities, which are predicated on the assumption of unfettered short selling.

Keywords: Short selling; margin risk; recall risk; optimal stopping; free-boundary problem; limits to arbitrage (search for similar items in EconPapers)
Date: 2022
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Working Paper: Short Selling with Margin Risk and Recall Risk (2019)
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DOI: 10.1142/S0219024922500078

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