Mispricing of Really Dirty Surplus and the Trading Behavior of Short Sellers

• In Event: Financial Reporting--Innovative Issues

Abstract

We study if short sellers arbitrage the complexity of really dirty surplus (RDS), and whether their trading incurs external benefits or costs to other investors. RDS, which arises from recognizing equity transactions at other than fair market value, is not readily observable from the financial statements. In this study we use comprehensive and unique security lending data and find that shorting demand increases, yet shorting supply decreases one year prior to a financial statement release date for firms reporting large negative RDS. This finding indicates that short sellers arbitrage RDS, but RDS stocks are not available when they are in demand. This phenomenon is stronger, when RDS arises from merger using the pooling-of-interest method, share-based mergers and acquisitions with control discounts and convertible bonds or preferred stocks or other dilutive securities. The RDS hedge returns are significant and positive only for portfolios with low short selling activities. However, we find evidence that insiders fail to arbitrage RDS, probably due to insider trading regulations. Overall, compared to other informed traders, short sellers thus help to mitigate the market mispricing of RDS items and move the equity price close to its fundamental value.

Authors

• Hyun (Shana) A Hong, University of California-Riverside

• Thomas Kim, University of Tulsa

• Barry Mishra, University of California, Riverside