The Information Content of Short Interest: A Natural Experiment

Abstract

An increase in the cost of short selling should increase the bearish information content of short interest announcements by driving relatively uninformed short sellers out of the market (Diamond and Verrecchia, 1987). We extend the Diamond and Verrecchia model to include short selling against the box and we test the extended model using a natural experiment based around the Tax Payer Relief Act of 1997 (TRA97). TRA97 made short selling more costly for those shorting against the box. Consistent with the implications of our extended model, this increase in short selling costs strengthened the negative relationship between short interest and subsequent stock performance post-TRA97.

Keywords: Sort Interest, Short Sale Against the Box, Tax Payer Relief Act of 1997

JEL Classification: G10, G14, H29