Two Essays on Short Sellers

This dissertation examines the role of short sellers in our capital markets. The first chapter examines the impact constraints on short sellers have on the liquidity. Prior literature has struggled to cleanly identify whether constraining short sellers is harmful or not for liquidity. We exploit a plausibly exogenous shock to shorting supply that occurs on dividend record dates to test the relation between shorting constraints and market quality. This shock arises due to a combination of equity settlement rules and the tax treatment of the payments in lieu of dividends that stock lenders receive when they loan their shares. We find a temporary degradation in liquidity on dividend record dates in the form of larger effective spreads. Our evidence that liquidity deteriorates on dividend record days, especially in stocks that likely have less slack in lending supply, suggest shorting supply constraints affect the cost of transacting faced by all traders. The second chapter investigates whether sell side equity analysts use the trading activity of short sellers in their information set. By taking advantage of a lagged disclosure of short interest I can identify the relationship between analysts’ actions and the trading of short sellers more directly than prior literature. I find that analysts exhibit an increased propensity to downgrade their recommendations for a stock after a disclosed increase in short selling. I also find a significantly positive relationship between changes in short interest and the likelihood of a downward EPS revision. Overall, these results suggest that market participants extract information from short-sellers’ trading activity.