In this paper we find evidence that deleveraging risk — the risk of losses due to a sudden and widespread reduction in stocks held by levered investors — affects equity returns.
Using various measures of short selling activity from multiple sources for a large sample of U.S. securities, we find that stocks with high short selling activity experience occasional and very large positive returns when tighter credit made it difficult for highly leveraged short sellers to hold their positions.
Consistent with prior research, we find that, on average, there is a negative relation between measures of short selling activity and future stock returns across a variety of measures of short selling activity. However, extending the past literature, we document evidence of occasional very large positive returns to short selling activity.
We further find that these episodes of positive returns are associated with (i) discrete liquidity events such as the quant crisis of August 2007 and the Lehman Brothers bankruptcy in September 2008, and (ii) reductions in funding capital availability as reflected in a variety of measures, such changes in TED spread, a measure of marketwide credit risk based on the difference between the interest rates on essentially risk-free short-term U.S. government debt and the rates banks charge on loans to other banks.
The effects of capital shocks are economically significant and persist for up to 60 trading days for most of the measures we used. The effect on equity lending quantities is also persistent: we find evidence of significantly lower quantities on loan for up to 60 trading days.