A Demand-Based Approach for Short-selling
Federico Mainardi, Joint Program in Financial Economics PhD student
I propose a model where the optimal portfolio allocation of a representative short-seller that faces margin requirements, collateral requirements and has to pay asset specific lending fees to access short trades obeys a characteristic-based representation à la Koijen and Yogo (2019). Despite omitting lending fees, structural estimation suggests that short-selling demand is naturally upward sloping and that elasticity of short-selling demand to market prices has steadily increased during the run-up to the financial crisis. Using the demand expression from the structural model, I propose a novel decomposition of short-interest that is suitable to disentangle a component explained by fundamentals and a residual component that reflects (at least) speculative motives. I use this novel decomposition to show that while betting against short-sellers is not profitable if one isolates crowded short trades based on standard or fundamental short-interest, it is indeed profitable if one isolates crowded short trades with significant speculative component.