Short Selling with Margin Risk and Recall Risk

Abstract: 

Short sales are represented as negative purchases in textbook asset pricing theory. In reality, however, the symmetry between purchases and short sales is broken by a variety of costs and risks peculiar to short sales. We develop a theoretical model in which the decision to cover a short position is the solution to an optimal stopping problem, and where short selling is subject to two specific frictions, namely, margin risk and recall risk. We analyse the effects of these short selling constraints on the optimal strategy, and quantify the loss of value suffered by the short seller due to each.