Do arbitrageurs amplify economic shocks, Working paper

Abstract: We examine whether arbitrageurs amplify fundamental shocks in the context of short arbitrage in equity markets. The ability of arbitrageurs to hold on to short positions depends on asset values: shorts are often reduced (increased) following good (bad) news about a stock. As a result, the prices of highly shorted stocks are excessively sensitive to economic shocks. Using monthly short interest data we find the following. (1) The price of a highly shorted stock is more sensitive to earnings news than a stock with little short interest. (2) The change in short interest around announcements (proxied by share turnover) is more sensitive to earnings surprises for highly shorted stocks. (3) For highly shorted stocks, returns to shorting are higher following better earnings news (after accounting for post earnings announcement drift). These results continue to hold when we exploit differences in short selling regulations across stock exchanges to instrument for the amount of shorting in a stock. These differential sensitivities tend to be driven by very good earnings news as opposed to very bad earnings news. Our findings point to the importance of limited arbitrage in affecting asset price dynamics and the potentially destabilizing role of speculators