Limits to Short Arbitrage With Takeover Risk

Abstract

We hypothesize that the risk of takeover bids creates significant limits to short-selling activities. A target firm’s price often increases substantially upon the announcement of a takeover bid, forcing short sellers to cover their positions. This causes additional short-term price overshoot. Therefore, short sellers require a higher rate of return when the likelihood of a takeover is high. Consistent with this intuition, ex-ante return predictability of monthly short interest increases with industry-level takeover activities and decreases with the implementation of takeover defenses. Our results suggest that efficient markets for corporate control may have unintended effects in inducing stock market inefficiencies.

Keywords: Short Selling, Limits to Arbitrage, Takeover

JEL Classification: G12, G14, G34