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cohen - Supply and Demand Shifts in the Shorting Market...

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Supply and Demand Shifts in the Shorting Market Lauren Cohen, Karl B. Diether, Christopher J. Malloy * June 4, 2005 Abstract Using proprietary data on stock loan fees and quantities from a large institutional investor, we examine the link between the shorting market and stock prices. Employing a unique identi- fication strategy, we isolate shifts in the supply and demand for shorting. We find that short- ing demand is an important predictor of future stock returns: an increase in shorting demand leads to negative abnormal returns of 2.54% in the following month. Second, we show that our results are stronger in environments with less public information flow, suggesting that the shorting market is an important mechanism for private information revelation into prices. * Cohen is at the Graduate School of Business, University of Chicago; Diether is at the Fisher College of Business, Ohio State University; Malloy is at London Business School. We thank Viral Acharya, Nick Barberis, John Cochrane, James Dow, Darrell Duffie, Gene Fama, Ken French, Julian Franks, Francisco Gomes, Tyler Henry, David Hirshleifer, Kewei Hou, Andrew Karolyi, Owen Lamont, Paul Marsh, Toby Moskowitz, Yigal Newman, Lubos Pastor, Jay Rit- ter, Jeanne Sinquefield, Rob Stambaugh, Jeremy Stein, Ralph Walkling, Ingrid Werner, Karen Wruck, and seminar participants at the NBER, London Business School, University of Chicago, and Ohio State for helpful comments and suggestions. We also thank Gene Fama and Ken French for generously providing data. Please send correspon- dence to: Christopher Malloy, London Business School, Sussex Place, Regent’s Park, London NW1 4SA, UK, phone: 44-207-262-5050 x3278, email: [email protected]
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Exploring the link between the market for short selling and stock prices is the subject of a large and growing literature. Despite the large body of work on this subject, the literature has not reached a consensus on two of the most fundamental questions in this area, namely: 1) what is driving the relation between shorting indicators and subsequent stock returns? and 2) what type of information is being revealed in this market? In this article, we address both issues. Our primary goal is to determine not only the existence, size, and persistence of the relation between shorting indicators and stock prices, but also to explore specifically what is driving the relation. In essence, we ask a simple question, which turns out to be a crucial one: is shorting demand or shorting supply the key ingredient? We believe this distinction is important as the drivers of shorting supply and shorting demand can be vastly different, and so have differing im- plications for future returns. Shifts in the demand curves represent shifts in the marginal benefit of investors. Shorting demand can be viewed as a measure of investor sentiment (e.g., Lamont and Thaler (2003)) or informed trading. In contrast, shifts in supply are driven by changes in marginal costs. An increase in shorting supply can be viewed as a relaxation of short sale constraints. Since a
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