Skewness, Short Interest, And The Efficiency Of Stock Prices
Utah State University – Huntsman School of Business
Vanguard’s move into PE may change the landscape forever
Utah State University
January 7, 2016
In this study, we examine the relationship between return skewness, short interest, and the efficiency of stock prices. Given that preferences for skewness have been shown to impact asset prices, we examine how skewness relates to market efficiency. We find that stocks with positive skewness and/or idiosyncratic skewness are less efficient than other stocks, which might be explained by overvaluation caused by investor preferences for positive skewness. Next, we document that short interest reduces both total skewness and idiosyncratic skewness. Finally, while prior research has shown that short selling can improve the efficiency of markets generally, we show that short interest’s ability to improve market efficiency is strongest in stocks with the highest skewness.
Skewness, Short Interest, And The Efficiency Of Stock Prices – Introduction
Recent evidence in a number of studies show that some investors have behavioral preferences for stocks that resemble lotteries. Using prospect theory, Barberis and Huang (2008) argue that some investors will overweight the tails in return distributions, which can lead to strong preferences for positive skewness and affect asset prices in a meaningful way. Empirical studies are supportive of the idea that some investors have preferences for stocks with return distributions that resemble lotteries. For example, Mitton and Vorkink (2007) show that some retail investors sacrifice mean-variance efficiency by intentionally under diversifying their portfolios in order to attain higher skewness. Additionally, more recent research provides support for the ideas in Barberis and Huang (2008) as stocks with positive skewness exhibit price premiums and subsequent underperformance (see Zhang (2005), Kumar (2009), Boyer, Mitton, and Vorkink (2010), Kumar, Page, and Spalt (2011), and Green and Hwang (2012)).
With this literature on skewness preferences as a backdrop, this study tests three hypotheses. First, we test whether stocks with the greatest skewness have the least efficient prices. This first hypothesis is motivated by the idea that investor preferences for lottery-like stocks can lead to contemporaneous overvaluation. The price premiums associated with lottery preferences may affect the price efficiency of stocks that resemble lotteries. To the extent that skewness is negatively related to the efficiency of stock prices, our second set of tests attempt to identify factors that might reduce the level of skewness in stocks. Specifically, we test whether short interest can reduce skewness in returns. The motivation for these tests relies on theory in Xu (2007), which nicely develops the relation between short interest and return skewness by presenting a model where short-sale constraints cause an important asymmetry in the price response to information signals. In particular, when differences in opinion exist, constraints induce equilibrium prices that react more to good news than to bad news resulting in price convexity across the information signal. Since skewness is a convex transformation, price convexity across signals will lead to greater skewness in the distribution of stock returns. We test whether short selling can reduce this skewness. Our final hypothesis naturally follows our first two sets of tests.
In particular, we hypothesize that the reduction in skewness caused by short interest can improve the informational efficiency of stock prices. Our third hypothesis is based on a broad literature that discusses the implications of short-sale constraints on the efficiency of financial markets. Theory in Miller (1977) suggests that, in the presence of heterogeneous beliefs, short-sale constraints can lead to overvaluation. On the other hand, Diamond and Verrecchia (1987) show that in a rational expectations framework, short-sale constraints do not bias prices upward, but constraints markedly reduce the speed of the flow of information into prices. Empirical research examining the relation between short selling and price efficiency seems to support the idea that short selling can improve the efficiency of financial markets (Chang, Cheng, and Yu (2007), Bris, Goetzmann, and Zhu (2007), Saffi and Sigurdsson (2011), Battalio and Schultz (2011), Blau, (2012) and Boehmer and Wu (2013)). While research generally supports the idea that short interest can reduce frictions in the flow of information, our third hypothesis suggests that short interest can improve the efficiency of stock prices through the mechanism of reducing skewness. Said differently, we determine whether the positive relation between price delay and skewness is reduced when conditioning on the level of short interest.
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