Can we prevent companies from going bankrupt as a result of their exposure to short selling?
Short selling is a transaction that consists in selling an asset that one does not hold but that one commits to deliver if a buyer is presented. It is therefore a bet on the decrease in value of this asset. If it is a share, it becomes a bet on the depreciation of the value of the company, or even its bankruptcy.
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The practice of short selling is to rent an asset, sell it at a higher price and then, buy it back at a lower price to return it to its original owner. There is thus a certain time gap where the position remains open between sale and purchase to generate profits. Therefore, by comparing the number of open short sales on total shares available on the market, one can determine a ratio called short interest, which expresses the percentage of people believing in a fall of the value.
In the midst of the economic crisis of 2020, the AMF has decided to ban short selling in order to protect the interests of companies by reducing their exposure to selling pressure.
In 1968, Professor Edward Altman published a paper in which he explained a ratio based on the financial data of companies, capable of generating an estimate of concerned companies’ probability of bankruptcy. Named Altman's Z-score, it is still widely used today and it is a good starting point for the search for companies in a fragile or even critical state.
By including short interest in Altman's model, resulting in an adjusted Z-score, one can gauge the effect of short selling on the probability of business failure. Therefore, the goal of this study is to weigh the weight of exposure to short selling by comparing the results of the adjusted Z-score predictions to the original model in order to try to improve Altman's model and thus allow analysts to enhance their work. If the model is improved to a fairly good confidence level, this will allow us to generally conclude that short selling is a crucial factor in the road towards a company's bankruptcy.