Heterogeneous Expectations, Short Sales Regulation, and the Risk‐Return Relationship

Abstract

AbstractThis paper examines, in a Canadian context, the effect of short sales regulation on the risk‐return relationship. It shows that, theoretically, the opportunity cost induced by short sales regulation is positively related to the dispersion of agents' beliefs and negatively related to the security's liquidity level. The model is tested over the sixty‐month period from January 1985 through December 1989. All the 13,079 observations are pooled into a time series cross‐sectional model. The results corroborate that a negative linear relationship links expected risky asset returns and the divergence of agents' beliefs. This negative relationship is consistent with the presence of opportunity costs resulting from short sales regulation when return beliefs are heterogeneous. However, the negative relationship between security returns and dispersion of beliefs is essentially confined to illiquid securities, that is, those monitored by a small number of analysts.