17 Week 7a. Short sales, “overpricing,” liquidity, downward-sloping demandSome big picture points1. Issue: do “demand curves for stocks slope down?” For example, do short restrictions (laws,regulations as in Lamont, or IPO no-flipping rules, lockup, etc.) prop up stock prices? Doespredictable December tax-loss selling drive prices down? Do roses cost more on Valentine’sday?(a) Old days: “Of course!”(b) Efficient markets: “Not at all. Arbitrageurs come in and set prices right.”(c) EM: There should be no such thing as “demand for shares”. Price equals present valueof the company’s dividends, period.(d) Now “Maybe a little bit, in special circumstances.”(e) I.e., If you show up at 3 AM with a truckload of tomatoes, do you get full price?i. A: Noii. If you show up every night at 3 AM, y ou should.iii. Bill Gates announces sales of MS stock, with no price impact. —(f) The “downward sloping demand” can come fromi. Limited risk-bearing ability of a small n u mber of traders. (But why are traderslimited?) “Segmented markets”ii. Asymmetric information: are you selling just to rebalance, or do you know some-thing?iii. More deeply, when selling do you look like you know something? This logic is subtlehowever. We do not expect a simple static demand curve. “price pressure” willdepend a lot on how much people think y ou know, ho w much you’ve advertised andmarketed your desire to sell/buy ahead of time, and so forth. bookbuilding andother marketing activities of IPOs, for exammple, are ways of getting a bunch oftomato buy ers to show up so there will not be much price impact.2. Are “prices efficient”?=1 − 25 =100450 =1002Small differences in return can add up to large differences in price if they last a long time.Th us, a large price deviation may not imply much of an “arbitrage opportunity” if it can lasta long time, and if there is ev en a small (1%/year) cost to maintaining a long term shortposition. It’s especially hard to maintain a long term short position. If you think a stock isoverpriced, but may take years to correct, t here’s not much you can do about it.326(a) Example. Two prices for the same security13. The Gordon Gro wth form ula (whic hassumes constant P/D, r, g forever) is =  −  =  + Return comes from dividend yield and dividend growth. If a price is 10% too big,then  is  × 10% too small. But D/P is a small num ber. If D/P = 4% (big),then 10% too big price means only 0.4% too small return. 0.4% is much larger than thetransactions costs to put on a short position. Even a 10% price error is only 40 bp ofreturn error on an annual basis . This is too small to long-short.(b) So is a 10% price error “irrational?” Is a 40bp return error “irrational?!”(c) “Ar bitrage” strategies are really “convergence trades”, bets that the price discrepancywill soon revert. They are risky because prices might widen temporarily. Even a purearbitrage can be risky! See the HSBC example belo w .(d) The short market is geared to short run speculative trades, not to long run short posi-tions.3. More back ground: Several other studies found small cases in which “t wo ways to get the samething” have (slightly) different prices. Royal Dutch/Shell (trade on different exc hanges);Closed-end funds. In each case there is a friction stopping you from arbitrage.4. Short problems(a) Must locate shares to borrow(b) Borrow, sell(c) Must post collateral — no zero cost investment! A long-short “zero cost” portfolio doesnot exist in practice; you need capital(d) You receive interest on collateral, but not full interest. Retail investors don’t even getthe interest. So, to short $100 of stoc k, you need cash, and you lose the in terest on thatcash. When it’s “Hard to short” stocks, you pay them for the priviledge of shorting.(e) Each day, you must adjust collateral. If stocks rise, you need to post more cash.(f) The contract is one day. Lender may request shares back. If you can’t borrow again,you must buy, closing out the position.(g) Most stocks can be shorted. Occasionally, there are just no shares around to borrow.This is especially true for hot IPOs.13We did this before with continuous time, but here’s a simple version in discrete time =+1+ +1=(+1+1+1)+1 =( +1)(1 + ∆)=(1+)(1+∆) − 1 ≈  + ∆With P/D constant returns m ust come from divided yieds and dividend gro wth.327Two good descriptions of short sales detailsFrom Duffie Garleanu and Peterse n, “Securities Lending, Shorting and Pricing” Journal ofFinancial Economics 66 (2002)2. The market for securities lendingIn a typical securities lending transaction, a would-be shorter, such as a hedge fund, wouldrequest a “locate” from its broker. Th e broker might locate the stock in its own inventory, or inthe accounts of those of its customers permitting the use of their securities for lending. Failing this,the broker could turn to a custodian bank, or to another potential lender. Natural lenders includeinstitutional investors such as insurance companies, index funds, and pension funds, who tend tohave large and long-duration buy-and-hold investments. Brokers ma y ev en have exclusive contractswith institutional investors for access to portfolios of securities for lending purposes, as in a recentmajor exclusive lending deal between Credit Suisse First Boston (CSFB) and California PublicEmployees’ Retirement System (CalPERS)14The broker’s search for lendable securities might beconducted using an electronic locate system, or by email, fax, or telephone. On May 22, 2001,ten large financial institutions announced the formation of Equilend, an automatic m ulti-brokerlending facility. (Notably, CSFB was not one of the ten initial participating firms.) A FinancialTimes reporter outlining the proposed role of Equilend described traditional methods for brokeringshorts as “labor-intensive, because the appropriate shares or securities can take time to locate.”(May 22, 2001, p. 28.)When encountering stocks that are, using the common industry term, “hard to locate,” brokerssometimes cannot “circle” the quantity of lendable shares requested. Brokers may offer “partialfills.” Occasionally, a significant amount of time ma y pass before the necessary stock can be