Limits of Arbitrage under the Microscope: Evidence from detailed Hedge Fund Transaction Data

(with Sandro Lunghi and Daniel Schmidt)

Review of Asset Pricing Studies (forthcoming)

We exploit detailed transaction and position data for a sample of long-short equity hedge funds to document new facts about the trading activity of sophisticated investors. We find that the initiation of both long and short positions is associated with significant abnormal returns, suggesting that the hedge funds in our sample possess investment skill. In contrast, the closing of long and short positions is followed by return continuation, implying that hedge funds close their positions too early and "leave money on the table." As we demonstrate with a simple model, this behaviour can be explained by hedge funds being (risk) capital constrained and facing position monitoring costs. Consistent with our model, we document that the return continuation following closing orders is more pronounced when these constraints become more binding (e.g., after negative fund returns or increases in volatility).

First to "Read" the News: News Analytics and High Frequency Trading

(with Donald B. Keim and Massimo Massa)

Review of Asset Pricing Studies 10, 2020, 122-178.

We investigate whether providers of news analytics affect the stock market. We exploit a unique identification strategy based on inaccurate news analytics that were released to the market. We document a causal effect of news analytics on the market, irrespective of the informational content of the news. Coverage in news analytics speeds up the market reaction in terms of stock price response and trading volume, but temporarily increases illiquidity and can result in temporary price distortions that might increase volatility and reduce market stability. Furthermore, we document that traders learn dynamically about the precision of news analytics.

Biased Shorts: Short Sellers' Disposition Effect and Limits to Arbitrage

(with Massimo Massa)

Journal of Financial Markets 49, 2020.

We investigate whether short sellers are subject to the disposition effect and whether this behavior affects stock prices. Consistent with the disposition effect, short sellers are more likely to close positions with higher their capital gains and this behavior is associated with lower profitability. Furthermore, stocks with high short sale capital gains experience negative returns, suggesting that short sellers' disposition bias affects stock prices, consistent with the model of Grinblatt and Han (2005). A trading strategy based on this finding achieves significant alphas. Overall, short sellers' behavioral biases limit their ability to arbitrage away mispricing caused by other traders' disposition effect.

Cash Windfalls and Acquisitions

Journal of Financial Economics 128, 2018, 287-319.

This article studies the effect of cash windfalls on the acquisition policy of companies. As identification I use a German tax reform that permitted firms to sell their equity stakes tax-free. Companies that could realize a cash windfall by selling equity stakes see an increase in the probability of acquiring another company by 19 percent. I find that these additional acquisitions destroy firm value. Following the tax reform, affected firms experience a decrease of 1.2 percentage points in acquisition announcement returns. These effects are stronger for larger cash windfalls. My findings are consistent with the free cash flow theory.

Banks' Equity Stakes and Lending: Evidence from a Tax Reform

(with Daniel Foos)

Journal of Banking and Finance 96, 2018, 322-343.

Several papers find a positive association between a bank's equity stake in a borrowing firm and lending to that firm. While such a positive cross-sectional correlation may be due to equity stakes benefiting lending, it may also be driven by endogeneity. To distinguish the two, we study a German tax reform that permitted banks to sell their equity stakes tax-free. After the reform, many banks sold their equity stakes, but did not reduce lending to the firms. Thus, our findings suggest that the prior evidence cannot be interpreted causally and that banks' equity stakes are immaterial for their lending.

Why Do Short Sellers Like Qualitative News?

(with Oleg Chuprinin and Massimo Massa)

Journal of Financial and Quantitative Analysis 52, 2017, 645-675.

Short sellers trade more on days with qualitative news, that is, news containing fewer numbers. We show that this behavior is not informationally motivated but can be explained by short sellers exploiting higher liquidity on such days. We document that liquidity and noise trading increase in the presence of qualitative news, enabling short sellers to better disguise their informed trades. Natural experiments support our findings. Qualitative news has a bigger effect on short sellers' trading after a decrease in liquidity following the stock's deletion from Standard & Poor's 500 and a smaller effect when investor attention is distracted by Olympic Games.

Working Papers

Passive Ownership and the Securities Lending Market

(with Pekka Honkanen and Daniel Schmidt)

We exploit quasi-exogenous variation in passive ownership around the Russell 1000/2000 cutoff to explore the causal effects of passive ownership on the securities lending market. We find that passive ownership causes an increase in lendable supply and short interest, while lending fees remain largely unchanged. Interestingly, the utilization ratio—i.e., the ratio of short interest over lendable supply—tends to go up, implying that shorting demand increases by more than what can be justified by a pure surge in lendable supply. We argue that this additional shorting demand results from an increase in the quality of lending supply as passive funds are less likely to recall stock loans. We show that, in line with this argument, the average maturity of stock loans increases and the likelihood of delivery failures decreases with higher passive ownership. Finally, we document that the additional shorting activity due to passive ownership improves information efficiency.

Spillovers from Repo to Securities Lending

Securities lending against cash collateral provides the borrower with the security and the lender with cash financing, thus being economically equivalent to repo. When repo rates spiked unexpectedly by over 300 basis points in September 2019, the value of cash financing increased significantly overnight, leading to a windfall gain. We find that securities lenders passed this windfall on to borrowers of government bonds but not to borrowers of equity or corporate bonds. We hypothesize that this is due to the lower negotiation power of equity and corporate bond borrowers, who usually have an interest in obtaining the specific security. Consistent with this idea, we find that government bond lenders didn’t pass on the windfall if the ex-ante lending fee was high.

Are euro-area corporate bond markets irrelevant? The effect of bond market access on investment

(with Conor T. Howells)

We compare how bond market access affects firms' investment decisions in the United States and the euro area. Having a bond rating enables US corporations to invest more and undertake more acquisitions. In contrast, in the euro area, bond ratings have no effect on investment decisions. Similarly, firms with bond ratings have higher leverage in the United States, but not in the euro area. This difference may be due to euro-area firms getting sufficient financing from banks. Consistent with this explanation, euro-area bond ratings became more relevant for investment after the banking crisis of 2008, when banks reduced their lending to firms.