Short sale constraints, disperse pessimistic beliefs and market efficiency — Evidence from the Chinese stock market

Abstract

In the Chinese stock market, the regulatory agency lists qualified stocks on announcement date and permits investors to sell short on the effective date, a practice that allows us to directly study the impact of short sale constraints. Applying an event study to 511 additions, between February 2010 and August 2013, of individual stocks to the list of securities qualified for short sale, we find that short sale constraints cause individual stocks to be overpriced and that such overvaluation is exclusively related to distortions associated with pessimistic beliefs. In addition, we observe lower volatility, skewness and extreme value frequency of stock returns after short sale constraints are lifted. This implies the emergence of a more appropriate distribution of returns and improved market efficiency at the individual stock level as the range of securities qualified for short selling expands.