Costly Arbitrage and Idiosyncratic Risk: Evidence from Short Sellers
WFA 2006 Keystone Meetings Paper
31 Pages Posted: 14 Aug 2006 Last revised: 27 Jan 2013
Date Written: June 15, 2009
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: Suggested Citation