| Using a novel database that contains information on the quantity of shares demanded and supplied in the equity lending market, I test a previously unexplored implication that follows from models of heterogeneous beliefs: the idea that short sales lead to increased volatility because they alter the supply of shares in the market. Because short sales and returns are endogenously determined, I use an instrumental variables framework to identify their relation. Specifically, I use shifts in the lendable supply of shares to identify the impact that short sales have on both the level and volatility of returns and I find evidence that short sales lead to higher contemporaneous volatility. Moreover, I find that this effect is strongest when demand curves are more likely to be downward sloping as a result of heterogeneous beliefs, a finding consistent with the predictions of heterogeneous belief models. In other words, I find that when there is disagreement among investors, the trades of short sellers lead to increased volatility. |
