Short selling and market mispricing

Authors: Eunju Lee

Publish Date: 2015/06/13

Volume: 47, Issue: 3, Pages: 797-833

PDF Link

Abstract

We provide evidence on short sellers’ exploitation of temporary mispricing in the equity market Using a mispricing indicator that measures deviations from a stock’s fundamental value we find higher levels of short selling for temporarily overvalued stocks The result is robust to controlling for short sale constraints and illiquidity and it is more pronounced when short sale constraints do not bind and stocks are illiquid We also find that informed short sellers are able to distinguish temporary overpricing from upward return momentum However when fundamental news is released short sellers focus on exploiting negative fundamental changes rather than temporary overpricing Short sellers contribute to market quality by correcting overpricing quickly over time but they do not destabilize the marketI thank the Editor ChengFew Lee two anonymous referees Ekkehart Boehmer Kris Jacobs Chinmay Jain Pankaj Jain Praveen Kumar Chris Murray Natalia Piqueira and seminar participants at the 2012 Financial Management Association Annual Meeting and the University of Houston for useful comments and suggestionsThe Kalman Filter algorithm is an econometric approach which provides the best estimates of unobservable state variables by minimizing the mean square error estimators of the state variables The Kalman Filter approach consists of two equations a measurement equation which describes the relationship between observable and unobservable data and a state equation which describes the path of the unobservable state variables By repeating prediction and updating steps in the algorithm we are able to estimate unobservable state variables

Keywords: