Short selling: definition
The selling of a security that the seller does not own, or any sale completed by the delivery of a security borrowed by the seller.
Short sellers assume that they will be able to buy the stock at a lower price than the price at which they sold short.
This is an advanced trading strategy, with many unique risks and pitfalls. Novice investors are advised to avoid short sales.
Short selling is done for two reasons:
- Hedging. Adopt short position to offset long position (and vice versa)
- Speculation
Short selling: players
Short sellers tend to be highly informed
(i.e., they are capable of identifying overvalued stocks)
(Boehmer et al., JF 2008)
Players include:
- Wealthy individuals
- Hedge funds
- Large institutions
- Day traders
Short interest:
- The total number of shares of a security that have been sold short.
Short covering:
- Purchasing securitiesin order to close an open short position.
This is done by buying the same type and number of securities
that were sold short.
Short squeeze:
- A situation in which a lack of supply and/or an excess demand for a traded stock forces the price upward. (see Gamestop video link later)
Short selling: pro or contra?
It is safe to say that short sellers are not the most popular people on Wall Street and elsewhere.
Many people consider short selling to be “unethical”, “unAmerican”, “against God”, and “playing against the home field” (see Lamont, 2012).
European countries ban short selling after markets plunge (FT 17/03/2020)
https://www.ft.com/content/b1b758d4-682e-11ea-800d-da70cff6e4d3
Short selling indeed has a dark side (Short and distort refers to an unethical and illegal practice that involves investors shorting a stock and then spreading rumours in an attempt to drive down its price).
why is short selling in general very useful:
- Provide liquidity – for target shareholders wanting to exit
- Identify overvalued stocks
- Make markets more efficient
- “Voice of reason” in bull markets
- “Blaming short sellers for a drop in the price is like blaming a thermometer for a drop in the temperature”.
Merger arbitrage: characteristics
Merger arbitrage involves the purchase of a target’s stock right after the merger announcement
Target’s stock price (post-announcement) typically trades at a 1-2% discount (or deal spread) to the offer of the bidder (due to time value of money and possibility that deal fails)
Allows merger arbitrageurs to:
Evaluate deal spread, calculate annual return
Estimate probability of deal failure
If spread is sufficiently large:
- Purchase shares in target firm
- Short acquirer’s stock (only for stock mergers to eliminate market risk)
Several characteristics of M&A activity are important for understanding merger arbitrage:
- Merger agreements sometimes fall apart
- Merger failure is typically idiosyncratic, but sometimes due to aggregate market conditions (witness the 2020 and 2022 crisis)
- Form of payment to the target determines the trades required to capture the merger arbitrage spread
“Arbitrage is basically buying a security in one market and simultaneously selling it in another market at a higher price, profiting from the temporary difference in prices. This is considered riskless profit for the investor/trader.” (investopedia.com)
Merger arbitrage is not a form of true arbitrage – arbitrageurs make a risky investment
Merger arbitrage: cash deals
- Most straightforward type of merger arbitrage
- Sears offers $62 for Land’s End (LE) (5/13/02)
- Price of LE prior to announcement: $51.02 (close of prior trading day)
- Price of LE immediately following announcement: $61.73
- Spread calculation:
Tender Offer for LE $62.00
less: Current Target (LE) Price –61.73
Gross Spread $ 0.27
add: Target Dividends 0.00
less: Commission Costs – 0.02
Net Spread $ 0.25 - Promised return:
= Net Spread / Cost of Purchase
= $0.25 / $61.75 = 0.405%
Merger arbitrage: cash deals
Assessment of deal failure risk in this case: low
- Signed definitive agreement
- Friendly deal
- Land’s End shareholders (incl. founder, chairman) representing 55% of shares agreed to tender
- Both companies in good financial shape so deal financing would not be an issue
- Little chance of government blocking merger
Merger arbitrage: stock deals ,fixeded exchange ratio
Assessment of deal failure risk: medium to high
Large amount of public criticism
High risk of antitrust intervention
Resistance from HP’s large shareholders
Merger arbitrage: stock deals ,fixeded exchange ratio
Investment decision – arbitrageur must assess:
Time to completion
Risk of deal failure
Risk of adjustment of deal terms
Possibility of delaying investment
Costs of shorting acquiring firm stock (unlike for cash deals)
What determines an arbitrageur’s interest in a particular deal?
the time it is estimated to complete the deal (the longer it is the less likely it is to complete or complete in changed conditions),
the hostility of the deal (the more hostile, the less likely to complete),
and any factor that affects the ease of short selling the acquirer’s shares in an equity swap, for example
percentage of institutional ownership (+),
liquidity (+),
whether the acquirer pays dividends (-)
what are some more complex transactions
Payment to target shareholders may include securities (debentures, preferred stock, etc.)
> Security may not be publicly traded
> Considerable market risk, difficult to hedge
Transactions in which investors have a choice in the form of payment received – may choose to receive cash or acquirer stock subject to a prorated number of shares or dollar value
> Arbitrageur must accurately forecast other investors’ election decision – a difficult task
> Potential for high market risk – if arbitrageur miscalculates investors’ decisions, may have unhedged position
what are complex transactions
Many stock transactions do not have set exchange ratio at announcement date
- Collar stock merger example (not for exam)
- Floating exchange ratio
> Ratio determined by stock prices of firms during specified period before merger close
> Hedge – buy target stock at announcement and short buyer during pricing period (“Late hedge”)
Merger arbitrageur = selling insurance
explain
- Target shareholders can hold on to shares until deal completed, but may lose if deal fails
- Merger arbitrageurs provide liquidity that target shareholders demand to avoid blow-up risk
Merger arbitrage portfolio returns – diversified across several deals so as to reduce risk
explain
- usually uncorrelated with overall stock market
- Risk/return in the context of CAPM: assuming efficient markets, return to portfolio should be equivalent to risk free rate
Merger arbitrage excess returns
explain
- Large abnormal returns to merger arbitrage may suggest stock market is not very efficient at pricing merger targets
- Arbitrageurs are risk averse: must be compensated for bearing idiosyncratic risk, so excess return represents risk premium
Merger arbitrage: empirical evidence Price pressure caused by short selling
what are the Explanations for acquirer’s negative stock price reaction on announcement of a merger
- Negative NPV merger
- Signal of diminishing stand-alone growth opportunities for the acquirer
- Signal that stock was previously overvalued
- Selling pressure on the acquirer stocks due to hedging the deal spread by merger arbitrageurs
what is meant by “Merger arbitrageurs are very active throughout the takeover process”
- Act quickly at announcement of deal
- Build positions over time – depends on type of deal and relevant terms
- Arbitrageurs constantly monitor deal – will change portfolio due to forecast of deal timing
Merger arbitrage in action:
how do they Manage overall portfolio
- Arbitrageurs do not invest all funds in one deal
- Arbitrageurs diversify failure risk by investing in many deals – may limit amount invested in single deal or type of deal
