On Distinguishing Between Valuation and Arbitrage Motivated Short Selling

43 Pages Posted: 13 Mar 2007

See all articles by Hemang Desai

Hemang Desai

Southern Methodist University (SMU) - Accounting Department

Srinivasan Krishnamurthy

North Carolina State University - Poole College of Management

Kumar Venkataraman

Southern Methodist University (SMU) - Finance Department

Date Written: October 10, 2006

Abstract

The short interest data reported in the United States aggregate valuation shorts (motivated by a pessimistic opinion on firm value) and arbitrage shorts (motivated by various arbitrage or hedging strategies). However, the information content of these two sources of short interest is different and hence their association with future returns is expected to be different. In recent years, the association between short interest and future returns has weakened considerably, reflecting the increasing importance of institutions that execute arbitrage strategies. The primary contribution of this study is an empirical model that ex-ante helps differentiate valuation shorts from arbitrage shorts. In out-of-sample tests, we document that, consistent with theoretical predictions, the firms identified by the model as valuation shorts exhibit high short interest and poor future returns. Furthermore, firms identified as arbitrage shorts do not exhibit significant negative returns but instead exhibit characteristics associated with arbitrage strategies. The paper also identifies variables that are correlated with the information set of short sellers. We present an application that exploits the model's ability to ex-ante identify poor performers and discuss broader applications in other finance settings.

Keywords: informed short selling, fundamental analysis, stock returns

JEL Classification: G14

Suggested Citation

Desai, Hemang and Krishnamurthy, Srinivasan and Venkataraman, Kumar, On Distinguishing Between Valuation and Arbitrage Motivated Short Selling (October 10, 2006). Available at SSRN: https://ssrn.com/abstract=969432 or http://dx.doi.org/10.2139/ssrn.969432

Hemang Desai (Contact Author)

Southern Methodist University (SMU) - Accounting Department ( email )

United States
214-768-3185 (Phone)
214-768-4099 (Fax)

Srinivasan Krishnamurthy

North Carolina State University - Poole College of Management ( email )

Hillsborough Street
Raleigh, NC 27695-8614
United States

Kumar Venkataraman

Southern Methodist University (SMU) - Finance Department ( email )

United States
214-768-7005 (Phone)
214-768-4099 (Fax)

HOME PAGE: http://people.smu.edu/kumar/

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