Companies that borrow money from hedge funds often see a sharp rise in bets against their shares before the loans or loan amendments are announced, new research from a Schulich professor shows, suggesting that fund managers or others privy to these deals may be illegally trading ahead of the announcements, reported The Wall Street Journal on July 3, 2010:

The sharp spike contrasts with little change in the short selling of companies that borrow money from banks, according to the research.

“Hedge fund lenders, like banks, are ‘quasi-insiders’ and thus privy to private information about the performance of borrowing firms,” the authors of the paper write. “However, hedge funds are not subject to the same degree of oversight and regulation as banks.”

“It’s impossible to know if it’s hedge funds that are doing the shorting, but our study raises important questions about regulating hedge funds when they make loans,” says Debarshi Nandy, Assistant Professor of Finance at Schulich, one of the co-authors of the paper. The other researchers are [Associate Professor] Nadia Massoud and [PhD candidate] Keke Song, both also from York University, and Anthony Saunders, at New York University’s Stern School of Business.

The paper has been accepted for coming publication in the Journal of Financial Economics and tracks the trading of 105 U.S. companies that borrowed money from hedge funds between January 2005 and July 2007—a period when regulators began demanding more information about short selling.

The academics found that the average company receiving a new loan from hedge funds saw a 74.8% spike in the volume of short sales during the five days preceding announcement of the new loan, as compared with the volume of short selling 60 days before the deal.

The study was funded by a Social Sciences and Humanities Research Council of Canada (SSHRC) standard research grant.

Read the full article in The Wall Street Journal.

Republished courtesy of The Schulich School of Business' media blog.