The Price of Prospective Lending: Evidence from Short Sale Constraints



Institutional investors can generate revenue by lending shares to short sellers. In this paper, I show that security prices incorporate future lending profits. I build on the theoretical research by Duffie, Gârleanu and Pedersen (2002), who present a dynamic model of asset valuation in which the search for counter party is the mechanism through which lending fees increase and affect asset value. To determine whether institutional investors anticipate lending profits, I look at price behavior following a failure-to-deliver in the equity lending market. Failure-to-deliver represents situations in which it is difficult to locate securities available for borrowing, resulting in high bargaining power for the lender and prospective increases in lending profits. I use closed-end funds to capture the valuation effect. The results show that the prospect of future lending profits pushes the price of closed-end funds above its NAV. Closed-end funds with reported failures trade at a 2.56 percent premium. The failure premium is decreasing in the level of inventory and the number of active lending agents, consistent with lower bargaining power for lenders when demanding higher future lending fees. The results of this study imply that short selling constraints can cause prices to deviate from the intrinsic value due to the loss of information and the capitalization of future lending gains.
Contact information:
Sebastian Gryglewicz
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