Extrapolation Bias vs. Overconfidence: When Short Sale Constraints are Binding

Abstract

This paper combines the market friction and traders’ behavioural biases and explicitly sets up the scenario for short sale constraints are binding. The paper contributes to the literatures by comparing the differences of extrapolation bias and overconfidence’s impacts upon asset price, market liquidity and volatility when short sale constraints are binding. The results indicate that binding short sale constraints would lead to overvaluation, the extrapolation bias’ impact upon this overvaluation is exogenous and market state-dependent: it would aggravate the overvaluation in bull market and mitigate it in bearish market, and the magnitude of the impact positively depends on the direction and extent of extrapolation bias and the proportion of the informed traders with extrapolation bias who are non-binding by short sale constraints. However, the confidence’ impact upon the overvaluation is endogenous, and the more confident informed traders enter the market or the larger degree they overestimate the received private signal would both mitigate the overvaluation. Furthermore, when short sale constraints are binding, contrary to the case that extrapolation bias does not affect market liquidity and volatility, confidence would decrease market liquidity and increase market volatility if the precision of public information is above a certain threshold.