Short Arbitrage, Return Asymmetry, and the Accrual Anomaly

Abstract

We find a positive association between short selling and accruals during 1988-2009, and that asymmetry between the up-and downsides of the accrual anomaly is stronger when constraints on short arbitrage are more severe (low availability of loanable shares as proxied by institutional holdings). Short arbitrage occurs primarily among firms in the top accrual decile. Asymmetry is present only on NASDAQ. Thus, there is short arbitrage of the accrual anomaly, but short-sale constraints limit its effectiveness. (JEL G14, G11) Recently, market upheavals have renewed the perennial debate between those who view short selling as causing downward price distortion, and those who argue that short selling helps correct overpricing. 1 Short interest, the amount of short selling in a stock, provides a revealing window into the determinants of arbitrage activity and the extent to which arbitrage succeeds in eliminating mispricing. We test here whether short arbitrageurs respond to firm overvaluation, and whether they succeed in correcting it, by measuring the effect on short selling of a proxy for market misvaluation and accruals, and by testing whether constraints on short arbitrage affect the degree to which mispricing

Short‐Selling Risk

“…Using loan fees from the equity loan market, Geczy, Musto, and Reed (2002) suggest that short-selling constraints have a limited impact on well-accepted arbitrage portfolios such as size, bookto-market, and momentum portfolios. Using institutional ownership as a proxy for supply in the equity loan market, Hirshleifer, Teoh, and Yu (2011) examine the relation between short sales and both the accrual and net operating asset anomalies. They find that short sellers do try to arbitrage mispricings, but short sale constraints appear to limit their ability to arbitrage them away.…”

Optimistic Reporting and Pessimistic Investing: Do Pro Forma Earnings Disclosures Attract Short Sellers?

“…() find that high quarterly accruals are positively associated with short interest levels. Hirshleifer, Teoh, and Yu () find that short sellers arbitrage the accrual anomaly. We advance this literature by examining the relation between short selling and another indicator of earnings quality—pro forma earnings exclusions.…”

Short Selling and Earnings Management: A Controlled Experiment

“…Desai, Krishnamurthy, and Venkataraman (), Cao et al. (), Karpoff and Lou (), and Hirshleifer, Teoh, and Yu () report that short selling tracks discretionary accruals. Desai, Krishnamurthy, and Venkataraman () find that short selling leads the announcement of earnings restatements, and Karpoff and Lou () find that short selling accelerates the rate at which misrepresentation is detected.…”