Nº 22-21: Asset Pricing with Costly Short Sales

We study a dynamic general equilibrium model with costly-to-short stocks and heterogeneous beliefs. The closed-form solution to the model shows that costly short sales drive a wedge between the valuation of assets that promise identical cash flows but are subject to different trading arrangements. Specifically, we show that the price of an asset is given by the risk-adjusted present value of future cash flows which include both dividends and an endogenous lending yield. This pricing formula implies that returns satisfy a modified capital asset pricing model with an adjustment for the lending yield and sheds light on recent findings about the explanatory power of lending fees in the cross-section of returns. In particular, we show empirically that once returns are appropriately adjusted for lending fees, stocks with low and high shorting costs offer similar risk-return tradeoffs.