Dynamic Equilibrium with Costly Short-Selling and Lending Market
53 Pages Posted: 3 Feb 2020
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, who in turn pay shorting fees to lenders. We find that the equilibrium stock price increases in shorting fee, and both the stock price and shorting fee decrease in lenders’ size. We additionally show that the stock risk premium decreases in shorting fee, while the stock volatility is increased due to costly short-selling. Notably, we demonstrate that the equilibrium short interest increases in shorting fee and predicts future stock returns negatively. Furthermore, we find that short-selling risk matters in equilibrium, and show that a higher short-selling risk can lead to 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