The Cost of Shorting, Asymmetric Performance Reaction and the Price Response to Economic Shocks

Jose Ornelas and Pablo de Carvalho

No 383, Working Papers Series from Central Bank of Brazil, Research Department

Abstract: We propose and test a model that combines of performance-based arbitrage, short-sale constraints and costly arbitrage. In the model, after an unexpected good earning surprise, short covering causes a price overshooting for highly shorted stocks. However, this price reaction is limited by short-selling costs. Also, while short arbitrageurs are forced to reduce their positions after a negative return, positive returns have no immediate effect on their managed funds, i.e., we propose an asymmetric performance-based arbitrage. The paper empirically tests model predictions using Brazilian short-selling data. Results support the overshooting phenomenon and provide evidence that the intensity of the overshooting is influenced by short-selling borrowing fee. Results also suggest that arbitrageurs behave asymmetrically to good and bad earning news.

Date: 2015-03
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