The Limits to (Short) Arbitrage

Theoretical models often assume short selling is costless. We show that short selling is expensive precisely when arbitrage opportunities are greatest. We examine the determinants of short constraints over time and find that 94% of overpricing exists in persistently constrained stocks, which inhibits short selling as a mechanism for price efficiency. Using the dynamic determinants of these short constraints, we then develop a novel measure which allows us to quantify these short constraints monthly in each stock from 1996 to present. Our results show that the dynamic properties of short sale constraints are a crucial component of the limits to short arbitrage.