Does Short Selling Erode Market Liquidity?

Abstract

This study examines how stock market liquidity dynamically responds to the spike in short interest ratio and dissects the causal linkage between short interest ratio and stock market liquidity. Based on the analysis of monthly data from 1931M6 to 2013M7, the results show that the percentage change in the NYSE share volume turnover significantly drops structurally following the spike to the percentage change in the NYSE short-interest ratio. The Granger causality test also shows that there is a causal direction running from the percentage change in the NYSE short-interest ratio to the percentage change in the NYSE share volume turnover suggesting that short selling causes the erosion of stock market liquidity.

Keywords: short interest ratio, stock market liquidity, trading activity, SVAR

JEL Classification: G12, G14