18/2/2013: Short-selling and Markets Volatility

A large number of analysts and policy makers tend to believe that highly leveraged trading activity, especially that linked to HFT, is a significant, even if only partial, driver of markets volatility. The channel through this logic usually works is that in the presence of leverage, speed of positions unwinding in response to unforeseen events increases, thus amplifying volatility.

An interesting study by Harrison Hong, Jeffrey D. Kubik and Tal Fishman, titled "Do arbitrageurs amplify economic shocks?" (Journal of Financial Economics, vol 103 number 3, March 2012, pages 454-470) examined the impact of arbitrageurs' activity on stock performance. Based on quarterly data from 1994 through 2007 for NYSE, Amex, and Nasdaq, share prices were examined over two distinct sub-periods: one day before earnings announcement and one day after the announcement. Medium-term performance was analysed for two days before earnings announcement and 126 days after earnings announcement.

The authors find that:

1. Stock price reaction to earnings news is more severe in heavily shorted stocks than in stock with fewer short positions;
2. Changes in the short ratio and earnings surprises counter-move;
3. Share turnover as a result of large earnings surprises is higher for heavily shorted stocks as consistent with (1) above;
4. Positive earnings surprises push up the valu of heavily shorted shares (as consistent with (1) and (2) above)
5. Following positive earnings announcement, returns are higher (in general) for stocks with heavy shorting positions prior to the announcement since price appreciation post-announcement forces covering of short positions and triggers more demand for shares;
6. Consistent with (5) above, post-positive earnings announcement, previously heavily shorted stocks become better targets for further shorting;

Overall, the study finds that:

• Any earnings surprise in any direction (either positive or negative) leads to a corrective action by (either long or short) investors;
• The above increases price sensitivity to newsflow and thus volatility;
• Trading volume and stock price increase abnormally for heavily shorted stocks;
• The abnormal volatility and volume & price effects are temporary and in the medium terms, prices revert to the mean.

13/4/2012: Short-selling - more evidence that restriction hurt, not help financial stability

Keeping up with some old topics of interest, here is another paper studying markets efficiency within the context of short-selling bans of 2007-present. The study, titled “Price Efficiency and Short Selling” by Pedro A. C. Saffi and Kari Sigurdsson, forthcoming in Review of Financial Studies covers a unique, large set of stocks across a number of countries for the period of January 2005 - December 2008. Data is daily, covering lending and borrowing transactions in 12,621 stocks in 26 countries. The study covers more than 90% of global stocks in terms of market capitalization.

The core questions the authors attempted to answer are:

• What is the impact of short-selling constraints on financial markets?
• Do they make markets more or less efficient?

After Lehman Brothers’ bankruptcy in September 2008, in the US, SEC and the UK FSA restricted the short selling of particular stocks. The emergency order enacting the short-selling restrictions in 2008 by the SEC recognized the usefulness of short-selling for market liquidity and price efficiency, but it also claimed that: “In these unusual and extraordinary circumstances, we have concluded that, to prevent substantial disruption in the securities markets, temporarily prohibiting any person from effecting a short-sale in the publicly traded securities of certain financial firms, (...), is in the public interest and for the protection of investors to maintain or restore fair and orderly securities markets. This emergency action should prevent short selling from being used to drive down the share prices of issuers even where there is no fundamental basis for a price decline other than general market conditions.” Securities Exchange Act Release No. 34-58952 (September 18th, 2008). Following the US and UK, Germany banned short-selling in June 2010 for eurozone sovereign bonds and credit default swaps, claiming that short-selling “had led to excessive price shifts, which could have led to significant disadvantages for financial markets and have threatened the stability of the entire financial system.”

The study considers whether short-sale constraints affect price efficiency and characteristics of the distribution of stock returns of firms around the world. The study defines price efficiency “as the degree to which prices reflect all the available information, both in terms of speed and accuracy.”

The study finds that:

• Lending supply influences price efficiency so that “stocks with limited lending supply are associated with lower efficiency.”
• Higher level of lending supply is “associated with a greater degree of negative skewness and fewer occurrences of extreme price increases, but is not linked with extreme price decreases.” In other words, absence of restrictions on short-selling is not associated with significant presence of extreme downward pressures on stocks – something the bans on short-selling were designed to reduce.
• In the presence of short-selling restrictions, the decrease in skewness is “due to less frequent extreme positive returns, in line with the view that arbitrageurs cannot correct overvaluation as easily when short selling constraints are tighter.” Or put differently, presence of a short-selling ban reduces volatility – if at all – via reducing upward movements in the stocks, not the downward ones.
• Limited lending supply – consistent with short-selling restrictions – “does not affect downside risk and total volatility. We actually find that less lending supply and higher loan fees are associated with greater downside risk and total volatility.” In other words, the short-selling restrictions act in exactly the opposite direction to their intended objectives.

“These findings do not support the view expressed by regulators that unrestricted shorting can destabilize prices, while simultaneously supporting the academic findings that short-sale restrictions generally make market less efficient.”   

“The negative relationship between short-sale constraints and stock price efficiency is found at a stock level all over the world, and equity lending supply is an important driver of differences in price efficiency.”

Interestingly, the findings are robust to membership in the Organization for Economic Cooperation and Development (OECD) countries, and to endogeneity concerns.

Securitization is not 'evil', neither is short-selling, nor CDS

A recent paper, Securitization of Mortgage Debt, Asset Prices and International Risk Sharing (CESifo Working Paper No. 2527, downloadable here) provides a refreshingly calm and measured assessment of the effects of mortgages securitization on the markets stability via allowing for greater international diversification of macroeconomic risk. According to the authors, "by making mortgage-related risks internationally tradeable, securitization contributes considerably to better international consumption risk sharing: we find that countries with the most highly developed markets for securitized mortgage debt have consumption responses to a typical idiosyncratic business cycle shock that are 20-30 percent less (my emphasis throughout) volatile than those experienced by countries that do not allow for mortgage securitization. Our results are based on quarterly data from a panel of 16 industrialized countries and cover the sample period 1985-2008Q1. They are robust to a range of controls for other aspects of financial globalization, international differences in the structure of housing markets and the financial system etc. Against the backdrop of the subprime crisis, these findings inevitably raise the question whether securitization could not just facilitate risk sharing in tranquil times but that it actually fails to provide international insurance in severe crisis periods. Indeed, we find that international risk sharing decreases in global asset price downturns and increases in booms. But we do not find evidence that countries with more developed securitization markets are systematically more exposed to these fluctuations in the extent to which risk can be shared across national boundaries."

Funny thing - there is now growing academic literature on the positive effects of such 'evil' forms of fiance as short-selling. See for example here and here (arguing that short-selling is superior to put options and even analysts in predicting negative returns), here, here and here (suggesting that short-selling adds to price efficiency in the case of dividend manipulation), here (arguing that share prices adjust to their fundamentals-justified equilibrium faster when short-selling is less restricted), and here (indicating that bans or restrictions on short-selling can have destabilising effects on even such 'stable' markets as those for government bonds).

While many more papers are available on the subject, what is apparent from the recent events is that politically motivated regulatory interventions in financial markets are exactly what they say they are - politically motivated changes that have little do with markets stability or efficiency. This is precisely why we should actively resist the current political push for restricting securitization, just as we should resist the push for banning short-selling or speculation.

Update: ... and CDS are not bad either... see comprehensive discussion on CDS here. Obviously all evidence flies in the face of our quasi-literate (economically speaking) DofF boffins (recall my post here).