Short Sales, Limits to Arbitrage and Fundamental Value

“The presence of short sale constraints ensures that pessimistic investors’ negative information is not reflected in the stock price as they are not able to sell short, short sales hamper the tendency of the optimist to bid up prices.”

Introduction (Via SSRN)

Both the magnitude and constraints in short sales affect the valuation of stocks. Short sales alleviate overvaluation above and beyond rational and sentimental drivers of deviations from fundamental value. In the cross-section, stocks with prior short sales trade closer to fundamental value. Contemporaneously, high short sale activity increases the difficulty to short at the margin and as such increases the overvaluation. The evidence further indicates that short sales do not depress prices, there is no greater short sale demand for undervalued stocks, nor do we observe that short sales further reduce valuation levels. The existence of adverse opinions affects market valuation of a stock in that evaluations are likely to diverge, nonetheless it is the short sale limitation that drives overvaluation. The presence of short sale constraints ensures that pessimistic investors’ negative information is not reflected in the stock price as they are not able to sell short, short sales hamper the tendency of the optimist to bid up prices.

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08. September 2009 by Miguel Barbosa
Categories: Curated Readings, Finance & Investing | Leave a comment

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