Costly Arbitrage and Idiosyncratic Risk: Evidence from Short Sellers


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Previous studies have shown that heavily shorted stocks tend to have price run ups before being shorted and price declines afterwards. We find that idiosyncratic risk is associated with a more pronounced pattern. The difference in monthly abnormal returns between high and low idiosyncratic risk stocks averages 5.07% per month prior to entering the high short interest portfolio; in the months subsequent to entering portfolio the average is -3.05% per month. We find that idiosyncratic risk is persistent; firms maintain their relative level of idiosyncratic risk before and after entering the high short interest portfolio. These findings along with others suggest that idiosyncratic risk is not the result of a type of trading activity, such as arbitrage, or noise trading, or opinion divergence. The results do imply that idiosyncratic risk limits arbitrage. One interpretation of the results is that short sellers only take positions in high risk firms when the mispricing is large enough to compensate them for the cost of holding a volatile position.


Finance and Financial Management

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