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Question: What Is Short Selling, and Should It Be Allowed?

The document discusses short selling and whether it should be allowed. It presents Robert Engle's argument that short selling should be permitted as it allows negative information about a company to be incorporated into its stock price. However, the document argues that financial markets do not actually behave as assumed by the efficient market hypothesis. It notes that much trading is based on trend following rather than providing genuine information. The document expresses concern that short selling can be used to deliberately drive down a stock or currency price without valid reasons, potentially causing bankruptcy or default. It refers to episodes where hedge funds targeted Lehman Brothers and the Euro through short selling and maintains the position that short selling should be outlawed.

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Kaviya Kavi
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22 views2 pages

Question: What Is Short Selling, and Should It Be Allowed?

The document discusses short selling and whether it should be allowed. It presents Robert Engle's argument that short selling should be permitted as it allows negative information about a company to be incorporated into its stock price. However, the document argues that financial markets do not actually behave as assumed by the efficient market hypothesis. It notes that much trading is based on trend following rather than providing genuine information. The document expresses concern that short selling can be used to deliberately drive down a stock or currency price without valid reasons, potentially causing bankruptcy or default. It refers to episodes where hedge funds targeted Lehman Brothers and the Euro through short selling and maintains the position that short selling should be outlawed.

Uploaded by

Kaviya Kavi
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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‘The Crisis and Beyond’ is an open ended topic; with time there are new developments,

new facts come to light, new analyses and opinions are published. Under this heading I
want to comment from time to time on some of these.

In a video interview on bigthink, Nobel Laureate Robert Engle came out in defense of
short selling. Here is the complete passage:

Question: What is short selling, and should it be allowed?

Robert Engle: Well if you’ve got information about a company, or you believe that a
company is undervalued, you can go out and buy their stock and you can make some
profit on it. And if a lot of people feel like this company is undervalued and go out and
buy the stock, the stock price will go up reflecting the higher value of this company. You
might have information because you trade with them or because you’ve done some
research on them.

On the other hand, if you have information that a company is not as good as its stock
market valuation, you don’t have a way to sell that stock unless you already own it. And
so that information doesn’t get incorporated in the company’s stock price as fast if you
don’t allow short selling. And so allowing short selling is allowing people to sell – instead
of having to buy the stock and then sell it, which doesn’t do much; allow them to sell it,
and then buy it. In which case they can express that information and the idea is that you
would get more accurate valuation of companies by letting people express both their
positive information and their negative information through either long or short selling.
URL: http://bigthink.com/ideas/21579

Engle’s argument would be quite reasonable if financial markets actually behaved in the
manner assumed by the Efficient Market Hypothesis (EMH) as Professor Engle
evidently believes. The EMH implicitly assumes that: 1. all ‘information’ is genuine,
reflecting aspects of a relevant reality; 2. all agents act rationally on the available
information; and 3. assets are rationally priced given available information. Scholars
working in behavioral finance have questioned all of these assumptions. (See for
example the article by Tuckett in this Special Issue.) The financial crisis has further
eroded belief in the validity of the EMH.

In the present context it suffices to point out that a large and increasing share of trading
in financial markets, particularly computerized trading, is simply based on trend
following. The individual speculator believes that he can spot both the beginning and the
end of a trend ahead of other speculators and thus profit at their expense. While this
may be true of a few, it is in the aggregate evidently a delusion! As more and more
speculators jump onto a trend, they strengthen it without supplying any genuine
information about the situation of the company in whose stock they are trading.

When short selling is used to drive down the value of a stock or of a currency, other
investors may mistakenly believe that the declining price reflects genuine problems at
the underlying firm or country. In the extreme, the firm may be driven into bankruptcy, a
country into default.
Early in February 2010, the managers of some of the biggest hedge funds gathered in
New York to plan a concerted short selling attack on the Euro. Earlier, some of the same
hege funds had bet heavily against the already declining stock of Lehman Brothers,
accelerating the decline that ultimately led to the collapse of the firm.

These and other episodes involving credit default swaps are described in a February 26,
2010 article in the Wall Street Journal. URL:
http://online.wsj.com/article/NA_WSJ_PUB:SB100014240527487037950045750877418
48074392.html.

I maintain my position that short selling (especially on the ‘down tick’) and naked credit
default swaps should be outlawed.

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