The Relationship between Short Interest and Stock Returns in the Canadian Market

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This paper provides new insight into the relationship between short sales and stock market returns using a sample of stocks sold short in Canada. Short interest is defined in relation to trading volume. The results strongly support the assertion that short sales and excess returns are contemporaneously negatively correlated in Canada. The paper further finds that excess returns are more negative for small firms because the supply of shortable shares is constrained for these firms. Excess returns are less negative for stocks with associated options and convertible bonds. Importantly, the evidence is consistent with the proposition that informed traders short sell Canadian interlisted stocks in Canada, rather than the US, to exploit lower execution costs. Together the results suggest that less restrictive regulation of short sales will improve the efficiency of markets.