Costly Arbitrage and Idiosyncratic Risk: Evidence from Short Sellers

31 Pages Posted: 14 Aug 2006 Last revised: 27 Jan 2013

See all articles by Ying Duan

Ying Duan

Simon Fraser University (SFU) - Beedie School of Business

Gang Hu

Hong Kong Polytechnic University - School of Accounting and Finance

R. David McLean

Georgetown University - Department of Finance

Multiple version iconThere are 2 versions of this paper

Date Written: June 15, 2009

Abstract

Previous studies have shown that high short interest stocks have low subsequent returns. We test whether the persistence of this effect is due to costs limiting arbitrage. The arbitrage cost that we focus on is idiosyncratic risk which, regardless of the arbitrageur’s level of diversification, deters arbitrage activity. Consistent with costly arbitrage, we find that among high short interest stocks a one standard deviation increase in idiosyncratic risk predicts a more than 1% decline in monthly returns. Moreover, idiosyncratic risk does not predict returns across low short interest stocks, and short interest does not predict low returns across low idiosyncratic risk stocks. Our results are robust to commonly used proxies for both transaction costs and short sale constraints.

Keywords: Short sellers, short interest, short sale constraints, costly arbitrage, idiosyncratic risk, market efficiency

JEL Classification: G11, G12, G14, G29, M41, D80

Suggested Citation

Duan, Ying and Hu, Gang and McLean, R. David, Costly Arbitrage and Idiosyncratic Risk: Evidence from Short Sellers (June 15, 2009). Journal of Financial Intermediation, Vol. 19, pp. 564-579, 2010; WFA 2006 Keystone Meetings Paper. Available at SSRN: https://ssrn.com/abstract=992116

Ying Duan

Simon Fraser University (SFU) - Beedie School of Business ( email )

8888 University Drive
Burnaby, British Colombia V5A 1S6
Canada

Gang Hu

Hong Kong Polytechnic University - School of Accounting and Finance ( email )

M1038, Li Ka Shing Tower
Hung Hom, Kowloon
Hong Kong
(852) 3400 8455 (Phone)

HOME PAGE: http://ganghu.org

R. David McLean (Contact Author)

Georgetown University - Department of Finance ( email )

3700 O Street, NW
Washington, DC Washington DC 20057
United States

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