Dynamic Equilibrium with Costly Short-Selling and Lending Market
47 Pages Posted: 3 Feb 2020 Last revised: 22 Mar 2021
Date Written: December 9, 2019
We develop a tractable model of costly stock short-selling and lending market within a familiar dynamic asset pricing framework. The model addresses the vast empirical literature in this market and generates implications that support many of the empirical regularities. In the model, investors’ belief disagreement leads to the presence of stock lenders and short-sellers. To borrow stock shares, short-sellers pay shorting fees to lenders. Our main results for a costly-to-short stock in equilibrium are as follows. The shorting fee increases in belief disagreement. The stock price is positively, while its risk premium is negatively related to its shorting fee. The stock volatility is increased due to costly short-selling. More notably, the short interest increases in shorting fee and predicts future stock returns negatively. Higher short-selling risk can be associated with lower stock returns and less short-selling activity.
Keywords: short-selling, stock lending, belief disagreement, shorting fee, short interest, stock price, stock risk premium, volatility, short-selling risk, short-selling activity
JEL Classification: G11, G12
Suggested Citation: Suggested Citation