The Cost of Shorting, Asymmetric Performance Reaction and the Price Response to Economic Shocks

We propose and test a model that combines of performance-based arbitrage, short-sale constraints and costly arbitrage. In the model, after an unexpected good earning surprise, short covering causes a price overshooting for highly shorted stocks. However, this price reaction is limited by short-selling costs. Also, while short arbitrageurs are forced to reduce their positions after a negative return, positive returns have no immediate effect on their managed funds, i.e., we propose an asymmetric performance-based arbitrage. The paper empirically tests model predictions using Brazilian short-selling data. Results support the overshooting phenomenon and provide evidence that the intensity of the overshooting is influenced by short-selling borrowing fee. Results also suggest that arbitrageurs behave asymmetrically to good and bad earning news