Not all investors are the same when it comes to lending their securities | Researcher: Melissa Prado
Ownership Concentration limits taking advantage of arbitrage opportunities!
Arbitrageurs often use short selling as part of their trading strategies, borrowing securities they do not own to correct overvaluation. Short selling involves borrowing the asset in question, selling it, and then buying it back (hopefully at a cheaper price) to replace the borrowed asset. As the seller does not own the asset, the process of selling it creates a short position that must eventually be covered by buying it back on the market. The difference between the initial sale price and the price at which the asset was brought back represents the short seller's profit or loss.
Short-sale constraints, such as the inability to locate shares to borrow, loan fees, and the risk that a lender recalls borrowed shares, increase limits to arbitrage by reducing investors’ ability to short sell stocks.
While institutional investors often lend shares for a fee to generate income, the decision on whether to lend is not inconsequential for them. In particular, investors might be concerned that lending their stock may lead to a decline in stock price and thus the value of their stake.
Ownership structure matters!
A working paper by Nova SBE Professor Melissa Prado and co-authors shows that investors have heterogeneous preferences about security lending based on their own investment philosophy, investment horizon, and stake in the company.
- Blockholders, active investors, or those with short-term horizons withhold stock from the equity lending market because of concerns that short selling may lead to a decline in price, have negative feedback effects on corporate policies, and to an increase in the risk of losing monitoring control.
- Consequently, stocks with ownership tilted towards larger holdings, investors with short-term horizons, or active investors exhibit lower lending supply and greater short-sale constraints.
- Greater constraints leads to less pricing efficiency. Short-sale constraints related to ownership characteristics affects the speed at which prices adjust to new information revealed in earnings announcements. Stocks with more concentrated ownership exhibit smaller announcement-day reactions and larger post-earnings announcement drift.
This article is based on the working paper: “Ownership Structure, Limits to Arbitrage, and Stock Returns: Evidence from Equity Lending Markets”, which is joint work of Melissa Porras Prado (Nova SBE) Pedro Saffi (Judge Business School, Cambridge),and Jason Sturgess (Driehaus College of Business and Kellstadt Graduate School of Business, DePaul University)