To Lend or Not to Lend: The Effect of Equity Lenders’ Preferences on the Shorting Market and Asset Prices

Abstract

We study the relationship between asset prices and short sale constraints by investigating how characteristics of institutional investors affect their willingness to lend stock to short sellers. We find that stocks with higher portfolio weights and stocks in which institutional investors traded successfully in the past are less likely to be lent out. Using these characteristics, we instrument the component of the short interest that is due to short sale constraints arising from lenders’ preferences. We relate this short-sale constraint measure to future stock performance and find strong evidence that stocks with higher short sale constraints deliver lower future returns. This relationship is more pronounced for stocks with lower information transparency, consistent with the hypothesis that short sale constraints combined with the investors’ dispersion of opinion cause stock overvaluation.

Keywords: short-sale constraints, institutional investors, stock overvaluation

JEL Classification: G11, G23