Jesse Blocher and Matt Ringgenberg
Unpublished working paper - not for distribution
Publication year: 2016

Most asset pricing models assume short selling is costless. We show that (1) short selling is extremely expensive precisely when arbitrage opportunities are greatest and (2) the existence of option contracts plays a pivotal role in alleviating mispricing.  When stock lending alone enables short selling, stocks which are expensive to short (i.e., special) earn returns of only -0.09% in the next month. In contrast, when both stock loans and options exist, the subsequent return is -1.24%. Our results highlight the importance of time variation in short constraints.  Without options, special stocks are persistently constrained: lending fees decline by only 0.3% in the next month and 0.6% over the subsequent 12 months. With options, lending fees in special stocks decline by 1.6% and 6.7%, respectively. In other words, the existence of options is crucial to alleviating short constraints.  Moreover, using a measure of ex-ante mispricing, we show that 93.7% of relative overpricing opportunities exist in the constrained samples where options are not available or shorting is not possible.  In other words, short selling constraints are a significant limit to arbitrage.

  • Thanks to Karl Diether and Dennis Gromb for useful comments.
  • Under revision, paper coming soon.