The Market for Corporate Control as a Limit to Short Arbitrage

Abstract

We hypothesize that corporate takeover markets create significant constraints for short sellers. Both short sellers and corporate bidders often target firms with declining economic prospects. Yet, a target firm’s stock price generally increases upon a takeover announcement, resulting in trading losses to short sellers. Therefore, short sellers should require higher rates of return when takeover likelihood is higher. Consistent with this prediction, the return predictability of monthly short interest increases with industry-level takeover probability and decreases as takeover defenses are implemented. Our results suggest that efficient takeover markets create trading frictions for short sellers and can therefore inhibit market efficiency.

Keywords: Market for Corporate Control, Short Selling, Limit to Arbitrage

JEL Classification: G12, G14, G34