When Short Sellers Agree to Disagree: Short Sales, Volatility, and Heterogeneous Beliefs

Abstract

Using daily equity lending data, I find that short sales lead to significant price pressure, consistent with inelastic short-term demand curves for stocks. Because short sales and returns are endogenously determined, I use an instrumental variables framework to identify their relation. Specifically, I use exogenous shifts in the lendable supply of shares to identify the impact that short sales have on both the level and volatility of returns. I find a one standard deviation increase in daily short interest is associated with a 12 basis point decrease in returns and a 3.8% increase in log realized volatility. Consistent with theoretical predictions, I find that price pressure from short selling is strongest when demand curves are more likely to be downward sloping as a result of heterogeneous beliefs. The results suggest short sales exert considerable price pressure and may help explain the short interest return anomaly (Boehmer2009) as well as the excess volatility anomaly (Shiller1981).

Keywords: Demand curves, Equity lending, Price pressure, Short sales, Volatility

JEL Classification: G12, G14