In the official statement of the Securities and Exchange Act of 1934 a short sale is defined according to Rule 3b-3 as “any sale of a security which the seller does not own or any sale which is consummated by the delivery of a security borrowed by, or for the account of, the seller.” In simple terms, a short sale transaction is like buying a stock – but in reversed order: it means to sell first and to buy later. Thus, short sellers benefit as corporate stock prices fall and lose when stock prices gain. However, legal and institutional restrictions as well as the limited availability of shares for short sales make short selling a costly transaction. Hence, Diamond and Verrechia (1987) argue that only informed investors with very negative information will enter into these trades assuming a rational expectations framework. Motivated by this theoretical prediction, the financial economics literature has tested this view empirically by investigating the relationship between levels or changes in short interest, i.e. the stock of open short positions that has not yet been repurchased and closed out, and subsequent stock returns.
KeywordsStock Price Stock Return Abnormal Return Hedge Fund Short Selling
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