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Arbitrage Trading: The Long and the Short of It
Texas A&M University
University of Notre Dame
University of North Carolina at Greensboro
We examine net arbitrage trading (NAT) measured by the difference between quarterly abnormal hedge fund holdings and abnormal short interest. NAT strongly predicts stock returns in the cross-section. Across ten well-known stock anomalies, abnormal returns are realized only among stocks experiencing large NAT. Exploiting Regulation SHO, which facilitated short selling for a random group of stocks, we present causal evidence that NAT has stronger return predictability among stocks facing greater limits to arbitrage. We also find large returns for anomalies that arbitrageurs chose to exploit despite capital constraints during the 2007–09 financial crisis. We confirm our findings using daily data. (JEL G11, G23)
Received September 1, 2016; editorial decision May 28, 2018 by Editor Andrew Karolyi. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.
We are grateful to Andrew Karolyi (the Executive Editor) and an anonymous referee for valuable advice. We thank Charles Cao, Roger Edelen, Samuel Hanson, Johan Hombert (Paris conference discussant), Byoung- Hyoun Hwang (AFA discussant), Hagen Kim, Weikai Li (CICF discussant), Bing Liang, Jeffrey Pontiff, Marco Rossi, Kalle Rinne (Luxembourg conference discussant), Thomas Ruf (EFA discussant), Clemens Sialm, Sorin Sorescu, Zheng Sun, Robert Stambaugh, Wei Wu, Jianfeng Yu, and seminar and conference participants at McMaster University, Miami University, Texas A&M University, University of Hawaii, University of Notre Dame, the 2015 European Finance Association Meeting in Vienna, the 4th Luxembourg Asset Management Summit, 2015 Macquarie Global Quantitative Research Conference in Hong Kong, the 2016 American Finance Association Annual Meeting in San Francisco, the 8th Annual Hedge Fund Research Conference in Paris, the 2016 China International Conference in Finance in Xiamen, and the 2016 Financial Management Association Meeting in Las Vegas for helpful discussions and comments. Chen acknowledges financial support from the Republic Bank Research Fellowship at Texas A&M University. Da acknowledges financial support from the Zych Family Fellowship at the Notre Dame Institute for Global Investing. We are responsible for all remaining errors. Supplementary data can be found on The Review of Financial Studies Web site. Send correspondence to Yong Chen, Department of Finance, Mays Business School, Texas A&M University, College Station, TX 77843–4218; telephone: (979) 845–3870. E-mail: email@example.com.
© The Author(s) 2018. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For permissions, please e-mail: firstname.lastname@example.org.
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SHORT-STOCKS: Shorting a stock means opening a position by borrowing shares that you don't own and then selling them to another investor. Shorting, or selling short, is a bearish stock position in other words, you might short a stock if you feel strongly that its share price was going to decline. Short selling is an investment or trading strategy that speculates on the decline in a stock or other securities price. It is an advanced strategy that should only be undertaken by experienced traders and investors. Traders may use short selling as speculation, and investors or portfolio managers may use it as a hedge against the downside risk of a long position in the same security or a related one. Speculation carries the possibility of substantial risk and is an advanced trading method. Hedging is a more common transaction involving placing an offsetting position to reduce risk exposure.
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Hedge Fund Holdings and Stock Market Efficiency: We study the relation between hedge fund equity holdings and measures of informational efficiency of stock prices derived from intraday transactions as well as daily data. Our findings support the role of hedge funds as arbitrageurs who reduce mispricing in the market. Hedge funds invest in stocks that are relatively inefficiently priced, and the price efficiency of these stocks improves after hedge funds increase their holdings. Hedge fund ownership contributes more to efficient pricing than ownership by other types of institu- tional investors. However, stocks held by hedge funds experienced large declines in price efficiency during several liquidity crises.
Short interest, returns, and fundamentals: We show that short interest predicts stock returns because short sellers are able to anticipate bad news, negative earnings surprises, and downward revisions in analyst earnings forecasts. They appear to have information about these events several months before they become public. Most importantly, the cross-sectional relation between short interest and future stock returns vanishes when controlling for short sellers’ information about future fundamental news. Thus, short sellers contribute, in a significant manner, to price discovery about firm fundamentals, but the source of their information remains an open question.
SHORT INTEREST AND STOCK RETURNS: Using a longer time period and both NYSE Amex and Nasdaq stocks, this paper examines short interest and stock returns in more detail than any previous study and finds that many documented patterns are not robust. While equally weighted high short interest portfolios generally underperform, value weighted portfolios do not. In addition, there is a negative correlation between market returns and short interest over our whole period. Finally, inferences from short time periods, such as 1988 1994 when the underperformance of high short interest stocks was exceptional or 1995 2002, when high short interest Nasdaq stocks did not underperform, are misleading.
Aggregate Short Interest and Market Valuations: The spectacular rise and fall of stock prices during the recent dot com bubble period has been accompanied by a surge of interest in the topic of short-selling.
Arbitrage Trading: The Long and the Short of It: We examine net arbitrage trading (NAT) measured by the difference between quarterly abnormal hedge fund holdings and abnormal short interest. NAT strongly predicts stock returns in the cross section. Across ten well known stock anomalies, abnormal returns are realized only among stocks experiencing large NAT. Exploiting Regulation SHO, which facilitated short selling for a random group of stocks, we present causal evidence that NAT has stronger return predictability among stocks facing greater limits to arbitrage. We also find large returns for anomalies that arbitrageurs chose to exploit despite capital constraints during the 2007 09 financial crisis. We confirm our findings using daily data. (JEL G11, G23)
Dedicated Short Bias Hedge Funds Just a one trick pony: During the recent period of significant market unrest in 2007 and 2008 dedicated short bias (DSB) hedge funds exhibited extremely strong results while many other hedge fund strategies suffered badly. This study, prompted by this recent episode, investigates the DSB hedge funds performance over an extended sample period, from January 1994 to December 2008. Performance evaluation is carried out both initially at the individual fund level and then on an equally weighted dedicated short bias hedge fund portfolio using three different factor model specifications and both linear and nonlinear estimation techniques. We conclude that DSB hedge funds are indeed more than a one trick pony. They are a significant source of diversification for investors and produce statistically significant levels of alpha. Our findings are robust to the specification of traditional and alternative risk factors, nonlinearity and the omission of the flattering credit crisis period.
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Instructions for Form 1099-B IRS: Proceeds From Broker and Barter Exchange Transactions. For whom the broker has sold (including short sales) stocks, commodities, regulated futures contracts, foreign currency contracts (pursuant to a forward contract or regulated futures contract), forward contracts, debt instruments, options, securities futures contracts, etc., for cash.
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