This paper explores the informality of short selling inefficiencies, the potential information gain on short selling errors by financial institutions to use their data advantage in identifying investment firm efficiencies, and exploring the impact of short selling on firm asset allocation. We argue that the process of announcing the intention to short sell will likely change the price of the stock because the pricing effect of this announcement is correlated with the announcements and the timing of announcements across markets. We further argue that firms have little control over the duration of the time periods for which they will decide to execute the option. Lastly, we explore the implications of this practice on capital budgeting and liquidity options.
To address these issues, we use a novel financial engineering approach called the firm-specific price mechanism. This method highlights that firms can use prior decisions and historical data to improve their efficiency in generating and managing firm-specific price signals. We derive firm-specific price signals from key valuation and liquidity features of specific assets using a finite sample of historical and current fixed-income securities. Using this information, we then exploit the mutual relationship between expected asset returns and stock price volatility to identify efficient strategies for allocating capital between different economic scenarios.
Our main results indicate that most registered firms are effectively diversifying their balance of equity between primarily long-term investments and short-term investments. However, very few firms manage to channel more than a small portion of their balance between their various fixed-income instruments. The fact that most registered firms take equity investment decisions to only a few years before making a definitive decision to sell their stocks suggests that the decision to buy is not based on adequate research and analysis. Further, as the timing of investment decisions often depends on bank financing requirements, the duration of an equity investment may not necessarily be within the control of the management.
There are several constraints on firm decision-making. One constraint is the time-cost benefit of making investment decisions. The time-cost is represented by the firm’s operating costs divided by the firm’s potential profits. If a firm takes long-term investment decisions and does not earn significant profits over that period, the firm will have to divert a significant portion of its operating budget to compensate for the short-term loss of funds. The second constraint relates to the spread of risk among portfolio equity and credit bonds. The spread reflects the credit risk inherent in the ownership structure of the firm and the possible effects of adverse market movements on bondholders or other forms of collateral.
Most importantly, effective management of firm investment decisions requires the identification and assessment of all risks. Some of these include the effect of changes in general economic factors, changes in company-wide sales and manufacturing output, changes in industry mix and investment practices. These factors can collectively lead to an ineffective allocation of financial resources between firm units. To understand investment decisions, it is important for managers to understand the relationship between equity and financial risk. Managerial skill in identifying and understanding the risks inherent in firm mixtures will facilitate sound decision-making.
Effective management of investment also requires efficient communication across all levels of the firm. This includes thorough internal communication, including information concerning investment objectives and the investment strategy, as well as among key investment managers, investment personnel, finance, and credit team members. Investment managers must be alert to changes in financial markets and business industries. Financial information needs to be routinely updated so that firm’s senior management can assess the day-to-day performance of the company.