Thursday, 30 April 2009

Shorting geekery

For those sad enough to share my interest in the pros and cons of short-selling, I direct you to the FSA's discussion document on the subject. In addition to providing a good overview of what shorting is (including varients like naked shorting) it contains a review of academic studies of shorting, and shorting constraints.

There's some really interesting stuff in there (if you find this kind of thing interesting) and the FSA's general stance is, as they often stated, that shorting is a legitimate market practice. They are also basically supportive of the idea that it allows negative sentiment to be expressed, and thus contributes to efficent price formation and liquidity (points I'm not sold on personally to be honest).

Just to be absolutely clear - so I'm not misrepresenting the paper - the FSA basically thinks shorting brings benefits.

Now I've got that out of the way I want to flag up one study in the literature review which takes a negative view:
Bris et al (2007) assess the empirical significance of concerns about the destabilising effects of short selling. They analyse cross-sectional and time-series information from forty-six equity markets around the world for the period 1990-2001. They look at both the frequency of extreme negative market returns and the skewness of market returns. Their results suggest that short sales do not affect the frequency of extreme negative returns. However, without short selling restrictions, extreme returns become more negative. To better control for cross-country variations, Bris et al also conduct an event study of the impact of removals of short selling restrictions in five countries. Once short selling is permitted and practised in these countries, the negative skewness of market returns increases marginally.

We found no other research on the hypothesis that short selling may amplify price swings. This may be because this hypothesis is difficult to separate empirically from the hypothesis that short selling conveys negative information about stocks to the market and thus contributes to efficient pricing. Both hypotheses are consistent with the observation that increased short selling is followed by negative abnormal returns.

The second para is the FSA's commentary and the bit I've emphasised is key for me because it cuts to the heart of my own wariness about the efficiency argument. To my mind it's all tied up with to what extent you can really establish fundamental value, and who is in a position to judge it. It feels to me that proponents of shorting as an aid to efficieny are taking for granted that those shorting have a good view of what the company is 'really' worth, hence expressing negative sentiment will bring valuations back to earth. But the excerpt above demonstrates that actually it's difficult to split out 'expressing negative sentiment' from 'amplifying price swings', because in order to do so you would presumably need to know what the asset being shorted was 'really' worth.

Ho hum.

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