Do Arbitrageurs Amplify Economic Shocks?
52 Pages Posted: 2 Mar 2007 Last revised: 4 Jun 2011
Date Written: June 1, 2011
We test the hypothesis that arbitrageurs amplify economic shocks in equity markets. The ability of speculators to hold short positions depends on asset values: shorts are often reduced following good news about a stock. Therefore, the prices of highly shorted stocks are excessively sensitive to shocks compared to stocks with little short interest. We confirm this hypothesis using several empirical strategies including two quasi-experiments. In particular, we establish that the price of highly shorted stocks overshoots after good earnings news due to short covering compared to other stocks.
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