Asset Prices and Welfare Under Short-Sales Constraints

Abstract

In this paper, we study how short-sales constraints affect asset prices and welfare in a rational expectations equilibrium model. In our model, investors trade in the market with two motives, to share risk and to speculate on private information, but they face short-sales constraints. Short-sales constraints limit both types of trades, and thus reduce the allocational and informational efficiency of the market. We show that limiting the two types of trades has opposite impact on prices and welfare. Limiting the short-sales driven by risk-sharing motives shifts the demand for the asset upwards, and thus increases its price. Limiting the short sales driven by private information, on the other hand, reduces the informativeness of the price and increases the uncertainty about the asset as perceived by the less informed investors. As a result, the demand for the asset on average decreases and so does its price. If the second effect dominates, short-sales constraints can actually cause asset prices to decrease. Although by reducing risk-sharing, short-sales constraints have a negative influence on welfare, they also reduce informed trading, which can improve welfare, at least for the less informed investors. The model also explains several empirical facts such as asymmetric post-event drift and no-news reversal and asymmetric stock price momentum.