Research and Academic Papers

So much has happened this past quarter yet so little has changed. To a certain extent the debt crisis that came to a head in 2008 resumed its destructive path this summer. An oft used analogy is one of the drug addict who did not come clean in 2008/9/10 but whose habit was partially controlled through replacing hard drugs with another artificial stimuli (Tarp/quantitative easing). During the past few months the money and political will ran out for further stimuli and the patient has truly gone cold turkey. Europe is an indebted mess, the US is monstrously overdrawn and China is slowing down. Unfortunately, European politicians were unable to show any leadership throughout the third quarter and global growth is running at a glacial pace. So how has securities finance navigated these choppy seas?

On November 9, 2011, Data Explorers and RavenPack hosted a presentation by Knightsbridge’s Dr. John Kittrell, who presented his analysis of news sentiment and stock lending signals in the US Equity market from 2007 – 2010.
This study uses news data from RavenPack News Analytics and U.S. Equities short selling data from Data Explorers. Samuel Pierson, Quantitative Product Specialist at Data Explorers joined Dr. John Kittrell for a lively and insightful discussion around the key findings from his soon-to-be published paper*, Behavioral Trends and Market Neutrality. Key topics included:

• How news sentiment signals can be used to outperform the equity market
• How to combine this data with diversifying stock lending metrics for enhanced risk adjusted returns
• How signals from both of these sources can be used to construct low turnover portfolios

Watch the recorded webinar now.

Headlines:

• The cost of borrowing EU Sovereign bonds has been rising across the member states.
• Bond borrowing costs show similar trends to CDS spreads – sometimes the CDS changes happen first, sometimes borrow costs take the lead.
• Both measures are subject to various distortions; in combination they provide a more robust measure of the pricing of default risk.

The fixed interest securities lending market has more than $6trn in lendable inventory. Government
bonds from the major economies are widely used as collateral in repo transactions, which allows
holders to borrow cash at the lowest possible rate1.

Highlights:

• Securities loan levels provide a good direct proxy for public short interest.
• Securities loan changes provide a very good and unbiased estimate of public short interest.
• Comparison of the two datasets helps to identify stocks with high levels of hedging.
• Securities loans may provide a measure of directional short selling for single stock names.

Short interest data for US Equities is published by the main exchanges twice per month, with a typical
lag of settlement date + 10. Securities loans from custodians to prime brokers (for onward lending to
hedge funds) are published daily by Data Explorers on settlement date + 2, and indicate
 

‘Reverse Torpedoes’ are stocks which show a sudden price spike. Research by Deutsche Bank1 (DB) shows that Securities Lending data can be used to identify likely candidates.

We characterize the legality, feasibility and incidence of short selling in a worldwide, multimarket framework. Some countries have no restrictions on short selling while others partially or completely ban short selling. We examine how these restrictions affect short selling of both domestic stocks in each country and of ADRs in the U.S. We use data from a variety of sources including Data Explorers, FINRA, Shortsqueeze, and DataStream. We find that home country short selling restrictions curtail home market stock borrowing and have international regulatory reach, curtailing short selling volume and short interest of the country’s ADRs in the U.S. markets. Our evidence rules out any large scale regulatory arbitrage by short sellers migrating their trading to less restrictive regimes. We also find evidence of reverse reach, which reduces the home-country underlying stock borrowing of ADR issuers when U.S. restrictions are stricter than home country restrictions. These effects survive in a multivariate analysis that controls for past returns, firm size, dividend yield, standard deviation of return, borrowing cost and institutional ownership. As an implication of regulatory reach, we find that the portfolio of ADRs from restrictive countries underperforms the portfolio of ADRs from less restrictive countries.

Recent evidence has shown that option volatility skews and volatility spreads between call and put options can be used to predict future equity returns. This study investigates two non-mutually exclusive reasons for this predictability – superior information discovery or superior information processing by option traders. We find that the option measures immediately prior to both scheduled (earnings announcements and 10-K/10-Q filings) and non-scheduled (e.g., product or customer announcements) information events have higher predictive ability of short-term returns around the information events than these measures in a more dated window, consistent with greater information discovery by option traders. On the other hand, we find that option measures after information events predict subsequent long-term returns. However, this predictive ability is evident for non-scheduled corporate announcements only, suggesting option traders’ superior information processing when the information is less anticipated and less structured....

The Report examines the effects of manager-level public short-selling disclosure requirements (“public SSDR”) on the equity markets they impact. We hypothesize that the public nature of such requirements, depending on the thresholds and frequencies of the disclosure requirement, would negatively impact equity investors’ inclination to engage in short-selling. We further posit that such a withdrawal of liquidity would have detrimental impacts on equity markets.

Our analysis is conducted on US and European equities. We defined UK and other European test groups of equities that were subject to short- selling disclosure requirements. We then defined control groups of US, UK and European equities with which to compare our test group.

Securities lending activity has grown tremendously, peaking in 2007 with a total value of securities on loan estimated at $5 trillion (Lambert 2009). Securities lending refers to a transaction in which the beneficial owner of the securities, normally a large institutional investor, such as a pension fund or mutual fund, agrees to lend its securities to a borrower, such as hedge funds; in exchange for collateral consisting of cash and government securities. But this market is not transparent and little is known about the lending and borrowing side of the market. Most institutions have a securities lending program and consider it to be an important source of revenue with estimates of $800 million in annual revenue for pension funds alone. At the same time, institutions have a fiduciary responsibility to vote their shares. Therefore, they must decide when to restrict lending and even recall shares already on loan.
To understand both the securities lending market and the implications of voting record date lending/borrowing for corporate governance, we use a comprehensive proprietary data set consisting of shares available to lend, shares that have actually been borrowed and are on loan, and the associated fee, for the period between January 2005 and December 2009. Our goal is first to shed light on the securities lending market and then to examine the relation between proxy voting and securities lending/borrowing.

We examine stock returns, order flow, and market conditions in the minutes before, during, and after short sales on the NYSE and Nasdaq. We find two very distinct types of short sales: those that provide liquidity, and those that demand it. Shorts that supply liquidity do so when spreads are unusually wide. These short sellers are also strongly contrarian, stepping in to initiate or increase a short position after fairly sharp share price rises over the past hour or so, and they tend to face greater adverse selection than other liquidity suppliers. In contrast, shorts that demand liquidity tend to be short-term momentum traders. However, there is no evidence that liquidity-demanding short sellers are any different from other liquidity demanders. Overall, liquidity-providing short sales are important contributors to stock market quality, and regulators and policymakers should keep these salutary effects in mind.

Combining a database of short sellers’ trading patterns with a database of news releases, we show that short sellers’ trading advantage comes largely from their ability to analyze publicly available information. Specifically, the prior finding that short sellers’ trades predict future negative returns (e.g., Boehmer, Jones, and Zhang (2008) and Asquith, Pathak, and Ritter (2005) is more than twice as strong in the presence of news stories. Further, the most profitable short sales do not appear to come from market makers, but from clients, and these client short sales are particularly profitable in the presence of news.

We find no evidence that short sellers anticipate news events, as the ratio of short sales to total volume is nearly constant around news periods, and when we do find differences between the timing of short sellers’ trades and the overall market, relative to other types of trading there is a significant increase in short selling after news stories.
We also find no evidence to support the idea the short selling around news events is more profitable because of liquidity effects; in fact, we find an increase in transaction costs on news days. Finally, short sellers’ ability to predict returns appears to be concentrated in many of the news categories in which short sellers trade relatively late, a finding consistent with the idea that short sellers’ advantage arises from their ability to process publicly available information.

Most stock exchange regulators around the world reacted to the 2007-2009 crisis by imposing bans or regulatory constraints on short-selling. Short-selling restrictions were imposed and lifted at different dates in different countries, often applied to different sets of stocks and featured different degrees of stringency. We exploit this considerable variation in short-sales regimes to identify their effects with panel data techniques, and find that bans (i) were detrimental for liquidity, especially for stocks with small market capitalization, high volatility and no listed options; (ii) slowed down price discovery, especially in bear market phases, and (iii) failed to support stock prices, except possibly for U.S. financial stocks.

Stock loans are extensively used by offshore investors to enhance their after-tax dividend yield on US stocks. We examine the impact of these off-market transactions on the price formation process in US stock markets. We document that dividend enhancement strategies result in a substantial tightening of the market for stock lending, especially for stocks with a high dividend yield. This tightening of the market has a dramatic impact on the price formation process. Stocks in the top quintile in terms of dividend yield that are also on special a month before the ex dividend date, experience an average price increase of 2% in the month leading up to the ex dividend date. After the ex dividend date these same stocks experience an average price reversal of about 2%.

Both institutional owners and short sellers decrease their positions prior to earnings announcements, and increase their positions in the post-announcement period.
Preannouncement changes in institutional holdings and short interest have significant explanatory power with respect to abnormal earnings announcement returns, where most of the power comes from institutions and short sellers closing positions in order to avoid losses.
Analysis of post-announcement returns indicates that aggressive trading by short sellers in reaction to earnings releases enhances price discovery and reduces their ability to profit from post-earnings announcement drift. The more muted reaction of institutional traders to earnings releases has no significant impact on earnings response coefficients, and allows institutions to successfully target stocks that underreact to earnings news.

This paper examines the link between stock prices and trading volume for the Hong Kong stock market. The results suggest that the information content of volume is strongest in trades initiated by short sellers. Based on the analysis of a proprietary database from Dataexplorers, shifts in the demand curve for the Hong Kong securities lending market are found to provide the most information about future prices. Shifts in supply are also found to be important, albeit to a lesser extent. In general, this paper finds strong evidence that short interest is a major channel for the transmission of information about prices.