Abstract: We decompose demand imbalances in the U.S. stock market into components at different levels of aggregation and estimate their respective price impacts using a unified approach. The results reveal that the price multipliers form a continuum that is higher at more aggregate levels. Our findings are inconsistent with information-based explanations but are largely consistent with mechanisms based on risk-averse liquidity providers. Our paper proposes a new demand measure for asset-pricing studies, provides support for the “flow-driven” view of aggregate price fluctuations, and bears implications for the modeling of demand-based price effects.
Discussant: Philippe van der Beck, Harvard University
Abstract: We construct novel, direct measures of net and gross short covering to examine when short sellers exit positions. We find that idiosyncratic limits to arbitrage, such as adverse stock price movements, volatility, and equity lending fees, are associated with significantly higher position closures. In contrast, we find little evidence that aggregate limits to arbitrage, including VIX, funding liquidity, and market liquidity, affect short covering. Short covering predicts future returns in the wrong direction, but only if it is induced by limits to arbitrage, consistent with the hypothesis that short sellers are forced to exit too early. It is also associated with lower price efficiency, higher future anomaly returns, and better performance of other informed traders. These results show that firm-level limits to arbitrage are important determinants of trading behavior and future returns.
Abstract: We study the equity market implications of a reform in the laws that govern trust investments,
implemented in a staggered fashion across U.S. states from 1986 to 2006. The
introduction of the prudent investor rule systematically alters the relative attractiveness of
stocks within the cross-section of U.S. equities for trust funds. As trust funds account for a
substantial fraction of institutional equity holdings in our sample period, our empirical setting
provides a rare opportunity to study the impact of a regulatory change on institutional
investor holdings and relative prices in the U.S. equity market. We show both theoretically
and empirically that, in response to the law change, trusts rebalance their portfolios away
from “prudent” stocks, which were implicitly advantaged under the old regulatory regime.
Stocks bought by trusts after the law change substantially outperform stocks sold by those
funds. In this new and unique setting, we derive an upper bound estimate on the price
elasticity of demand of the average U.S. stock of 11. Our results are in line with the inelastic
markets hypothesis.
Tim de Silva, Massachusetts Institute of Technology
Kevin Smith, Stanford University
Eric So, Massachusetts Institute of Technology
Abstract: We document the growth of retail options trading and provide evidence that retail
investors are drawn to options by anticipated spikes in volatility. Retail investors
purchase options in a concentrated fashion before earnings announcements, particularly
those with greater expected abnormal volatility. Comparing across asset markets, we
also find retail investors disproportionately trade options over stocks as anticipated
announcement volatility increases. In doing so, retail investors display a trio of
wealth-depleting behaviors: they overpay for options relative to realized volatility, incur
enormous bid-ask spreads, and sluggishly respond to announcements. These translate
to retail losses of 5-to-9% on average, and 10-to-14% for high expected volatility
announcements.
Discussant: Taisiya Sikorskaya, London Business School
