Asset pricing with costly short sales

Abstract

We study a dynamic general equilibrium model with costly-to-short stocks and heterogeneous beliefs. Costly short sales drive a wedge between the valuation of assets that promise identical cash flows but are subject to different trading arrangements. Specifically, we show that the price of an asset is given by the risk-adjusted present value of future cash flows which include both dividends and an endogenous lending yield. Once returns are appropriately adjusted for lending fees, stocks with low and high shorting costs offer similar risk-return tradeoffs, shedding light on recent findings about their explanatory power in the cross-section of returns.

Keywords: Shorting fees, Securities lending, Heterogeneous beliefs, Dynamic equilibrium.

JEL Classification: D51, D52, G11, G12