A Demand-Based Approach to Short-Selling
59 Pages Posted: 25 Apr 2023 Last revised: 2 May 2023
Date Written: April 14, 2023
I microfound and estimate a tractable demand system in which both the spot and the lending markets jointly clear. In the spot market, heterogeneous investors subject to short-selling constraints are complemented by an aggregate investment sector that is allowed to take both long and short positions. In the lending market, the long-short investor borrows stocks from a set of oligopolistic lenders in exchange for the payment of a lending fee. In equilibrium, the elasticity of short-selling demand to the spot market price is the result of two countervailing economic forces. On one hand, an exogenous increase in the spot market price leads to an increase in short-selling demand. On the other hand, the increase in short-selling demand prompts oligopolistic lenders to charge higher lending fees which in turn compress the demand for short positions. I show empirically that the second channel dominates and that the demand for short-selling is ultimately downward-sloping in the spot market price. Quantitatively, a 1% exogenous increase in the spot market price decreases short-selling demand by 0.32% to 0.64% on average. This result suggests that short-sellers do not correct but rather exacerbate deviations of stock market prices above their fundamental values.
Keywords: Short-selling, Asset demand system, Asset pricing, Market power
JEL Classification: G11, G12, G14, G23, L13
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