Toil and Trouble, Don't Get Burned Shorting Bubbles

11 Pages Posted: 19 Mar 2021

See all articles by Aaron Brown

Aaron Brown

New York University (NYU) - Courant Institute of Mathematical Sciences; AQR Capital Management, LLC

Richard Dewey

Royal Bridge Capital

Date Written: February 9, 2021

Abstract

Bubbles are among the most puzzling and controversial phenomena of financial mar- kets. Although rare, their cumulative impact on both investor returns and the broader economy can be great. One particular question that has motivated research is why shrewd short sellers don’t prevent excessive price increases.

The “limits to arbitrage” idea argues that correcting inefficient market prices is neither easy, cheap nor riskless. The “rational bubble” literature identifies situations in which being long the bubble is a better trade than being short, even if investors know for certain the bubble will pop. And there is a theory that bubbles only inflate after the shorts have suffered significant losses.

We examine the “short subprime” trade from 2005 to 2008 to evaluate these and other explanations. We argue that the short subprime trades had more risk than is commonly appreciated. We discuss how the opaque and illiquid nature of subprime mortgages deterred some investors from purchasing CDS contracts and note that other investors assessed the risk of counterparty failure, government intervention and unknown time horizon to be sufficient enough not to purchase CDS contracts.

In addition, we describe how factors such as performance convexity and credit convexity made the subprime short more profitable than most ex-ante calculations suggested. We also outline why the subprime short trade was ineffective at reining in the subprime bubble and how buying subprime after the crises was an equally, if not more attractive trade that potentially did more to mitigate the harm of the bubble. Looking back at the last major bubble with a decade of hindsight yields insights that might be helpful to market participants and policy makers thinking about future bubbles.

Keywords: bubbles, short trading, limits of arbitrage, The Big Short, subprime mortgages, credit convexity

JEL Classification: G1, G01, N2

Suggested Citation

Brown, Aaron and Dewey, Richard, Toil and Trouble, Don't Get Burned Shorting Bubbles (February 9, 2021). Available at SSRN: https://ssrn.com/abstract=3782759 or http://dx.doi.org/10.2139/ssrn.3782759

Aaron Brown

New York University (NYU) - Courant Institute of Mathematical Sciences ( email )

New York University
New York, NY 10012
United States

AQR Capital Management, LLC ( email )

Greenwich, CT
United States

Richard Dewey (Contact Author)

Royal Bridge Capital ( email )

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
1,271
Abstract Views
5,152
rank
19,779
PlumX Metrics