  Short sales are regarded 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 the latter. We formulate an
optimal stopping model in which the decision to cover a short position is
affected by two short sale-specific frictions---margin risk and recall risk.
Margin risk refers to the fact that short sales are collateralised
transactions, which means that short sellers may be forced to close out their
positions involuntarily if they cannot fund margin calls. Recall risk refers to
a peculiarity of the stock lending market, which permits lenders to recall
borrowed stock at any time, once again triggering involuntary close-outs. We
examine the effect of these frictions on the optimal close-out strategy and
quantify the loss of value resulting from each. Our results show that realistic
short selling constraints have a dramatic impact on the optimal behaviour of a
short seller, and are responsible for a substantial loss of value relative to
the first-best situation without them. This has implications for many familiar
no-arbitrage identities, which are predicated on the assumption of unfettered
short selling.
