Does Too Much Arbitrage Destablize Stock Price? Evidence from Short Selling and Post Earnings Announcement Drift.

Abstract

Stein (2009) suggests that too much arbitrage capital exploiting underreaction can lead to overreaction, pushing price further away from fundamental value. I test this hypothesis by investigating the relation between changes in short interest ratio around earning announcement and the subsequent drift return. There are two main findings in this paper. First, my results suggest that too much arbitrage capital does contribute to overreaction (with a t-statistics around 4 on average). These findings are robust to alternative sample periods or length of the window for drift calculation. Second, contrary to the findings in prior literature that show that short sellers mitigate the magnitude of drift, my results show that almost all of this effect are actually contributed by the observations that are more likely to represent overreaction.