OWNERSHIP STRUCTURE, EXPECTATIONS, AND SHORT SALES ON THE NASDAQ

Journal of Economics and Finance, Spring 2007 by Graham, J Edward, Hughen, J Christopher

Finally, and because short selling is a costly activity, we expect that the unanticipated amount of short interest provides a stronger signal regarding subsequent returns than the reported level of short interest standing alone. To address this question, we use the residuals from an equation estimating short interest to represent the unexpected level of short interest. Our fourth hypothesis is formulated in the following manner:

H4: The unexpected short interest does not have greater predictive power for future returns than the unadjusted level of short interest.

Extending earlier work, we also expect to find more short selling activity in stocks with options and greater divergences of analyst options.

Results

Cross-Sectional Analysis of Short Interest

To better understand the determinants of short interest, we investigate the relationships between sample firm characteristics and those firms' short-interest ratios. Logs of selected variables are provided to normalize the error terms. Traditional regression analysis is used to estimate the short-interest ratio.7 This function generates the expected level of short interest that is used later in the study.

The coefficient estimates and p-values for the cross-sectional analysis of the short-interest ratio are shown in Table 3. The equations are estimated for each of the 90 months in our sample, and the mean coefficient estimates are reported. This approach is used because the bid-ask spreads are narrowing and short-interest levels are increasing over virtually the entire study period. Without this control for time, our examination would find misleading relationships between the explanatory factors and the dependent variable. Table 3 provides estimates for two functions. In Equation 1, the observations are limited to firms with data on multiple analyst earnings estimates from I/B/E/S. This restriction reduces the sample size by 8.2% in the average month, but it allows us to incorporate the standard deviation of analysts' forecasts in our analysis. Equation 2 is estimated for the entire sample.

As shown in both equations in Table 3, in tests of our first hypothesis, inside ownership is positively associated with the short-interest ratio.8 Short sellers may become more active as managers are entrenched through greater ownership. Another plausible explanation suggests insiders may hedge their stock holdings. As inside holdings are sometimes offset by positions in collars, swaps, and other derivatives, with financial institutions that facilitate these transactions reducing their own risk by short selling stock, a positive relation between inside ownership and the short-interest ratio may arise. Our results do not indicate that corporate policies preventing insiders from holding shares in margin accounts exhibit significant pressure on the ability to borrow shares for short selling. Our analysis rejects H1, and it represents the first research to document the effect of inside ownership on short interest.

Our second hypothesis states that short interest is unrelated to institutional ownership, and it is also rejected by the data in our study. Both equations in Table 3 show that higher institutional ownership results in lower short interest. On the surface, these results seem to contradict D'Avolio (2002) where he shows that institutional ownership explains a significant portion of the variability in loan supply.9 However, the apparent inconsistency is likely a result of the characteristics of our sample, which consists of the largest Nasdaq stocks. D'Avolio finds 1,267 stocks that are unavailable for borrowing from a large institutional lending intermediary; 86% of these stocks are in the bottom size decile and 57% are priced under $5. The mean price of the stocks in our sample is $33.48 and the average institutional ownership is 51.63%. Thus, the stocks that are most difficult to borrow from institutions are typically not among the largest 200 firms on the Nasdaq.