Costly arbitrage and idiosyncratic risk: Evidence from short sellers

Ying Duan, Gang Hu, R. David McLean

Research output: Journal article publicationJournal articleAcademic researchpeer-review

42 Citations (Scopus)

Abstract

Previous studies have shown that high short interest stocks have low subsequent returns. We test whether the persistence of this effect is due to costs limiting arbitrage. The arbitrage cost that we focus on is idiosyncratic risk which, regardless of the arbitrageur's level of diversification, deters arbitrage activity. Consistent with costly arbitrage, we find that among high short interest stocks a one standard deviation increase in idiosyncratic risk predicts a more than 1% decline in monthly returns. Moreover, idiosyncratic risk does not predict returns across low short interest stocks, and short interest does not predict low returns across low idiosyncratic risk stocks. Our results are robust to commonly used proxies for both transaction costs and short sale constraints.
Original languageEnglish
Pages (from-to)564-579
Number of pages16
JournalJournal of Financial Intermediation
Volume19
Issue number4
DOIs
Publication statusPublished - 1 Oct 2010
Externally publishedYes

ASJC Scopus subject areas

  • Finance
  • Economics and Econometrics

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