Effect Of Short Sale Constraints Research Articles

CEO confidence matters: the real effects of short sale constraints revisited

CEO confidence matters: the real effects of short sale constraints revisited

Breadth of Ownership and the Cross-Section of Corporate Bond Returns

Using breadth of corporate bond fund ownership to proxy for the combination of short-sale constraints and divergence of opinions in the corporate bond market, this paper investigates whether and to what extent Miller’s overpricing theory holds for corporate bonds. Consistent with the theory, we document a significant and positive relation between changes in breadth and the cross-section of future corporate bond returns. Because of the bounded upside of debt, the ability of changes in breadth to predict returns appears to be less pronounced for corporate bonds relative to stocks. Furthermore, this predictability is stronger among bonds with higher credit risk, indicating that the effect of short-sale constraints and divergence of opinions on bond mispricing tends to be larger for riskier bonds with more upside potential and, thus, more scope for overvaluation. This paper was accepted by Lukas Schmid, finance. Supplemental Material: The internet appendix and data are available at https://doi.org/10.1287/mnsc.2023.4950 .

Value at risk, mispricing and expected returns

This study investigates how the relation between value-at-risk (VaR) and expected returns differs under different mispricing statuses. We find that a significantly negative VaR-return relation, defined as the VaR effect, is observed only for overpriced stocks, but not for underpriced stocks. Moreover, VaR has an amplification effect on mispricing, indicating that VaR captures risk that deters arbitrage and thus leads to an increase in mispricing. Our results are robust to alternative VaR definitions, subperiod analysis, different market states, and after controlling for other firm characteristics, well-known risk factors, and those variables that have been shown to have amplifying effects on mispricing. Finally, this study also examines the pricing effect of short sale constraints on the VaR effect under different mispricing statuses. Our findings suggest that the VaR effect observed in overpriced stocks becomes more severe as short sales are more constrained.

The dynamics of short sales constraints and market quality: An experimental approach

We test the effect of short sale constraints on market quality in an experimental setting. Short sale constrained securities trade at a premium, which is often higher than the difference between the view of the most optimistic investor and the fundamental value. Opinion dispersion contributes to overpricing; this result is more pronounced at the time opinion dispersion is induced. As time progresses, traders update their valuations with information from trading. Consequently, opinion dispersion narrows and its effect on overpricing dissipates. Under short sale constraints, the speed of price adjustment is slower, as prices never fully converge to their fundamental values.

Worldwide short selling regulations and IPO underpricing

We study the impact of country-level short selling constraints on IPO underpricing. Examining 17,151 IPOs from 36 countries, we find that IPO underpricing tends to be greater in countries that ban short selling or security lending and in countries where short selling is not practiced. Non-positive first-day returns are more common in countries where short selling is allowed, security lending is allowed, and short selling is commonly practiced. Short selling constraints exacerbate the positive relation between investor sentiment and underpricing. Additional evidence suggests that higher quality information environments may partially alleviate the effects of short sale constraints on underpricing.

The effect of short sale constraints on analyst forecast quality: Evidence from a natural experiment in China

We examine the effect of short selling on analyst forecast quality following the pilot program in China in 2010 that allows short selling for selected companies. We find that reduction in short sale constraints significantly improves analyst forecast quality for these pilot-firms when compared to non-pilot firms. Specifically, analyst forecast errors for pilot firms are smaller and forecast dispersions are narrower. Further, we show that the improvement of analyst forecast quality is more prominent for firms with lower prior price efficiencies and disclosure quality, and in locations with lower institutional development. Our findings suggest that short selling activities serve an important role in facilitating the speed of information incorporation and improving the information environment faced by firms.

CEO Confidence Matters: The Real Effects of Short Sale Constraints Revisited

This paper investigates the role of managerial biases in the real effects of limits to arbitrage. In a natural experiment setting with Regulation SHO, we find that the lifting of short sale constraints leads to a significant decrease in CEO confidence for pilot firms, and this result is more pronounced for pilot firms with financial constraints and stronger corporate governance. We further find that the real effects of Regulation SHO documented in the literature are primarily driven by such decrease in CEO confidence. Underconfident CEOs of pilot firms tend to decrease corporate investments, reduce earnings management, and improve social performance and employee relations following the removal of short sale constraints. Overall, we identify CEO confidence as a psychological channel through which capital market frictions influence corporate decisions and CEO investment behavior.

Leverage Effect Puzzle: A Rational Explanation

I study the effects of short sale constraints in a rational framework with asymmetric information. I consider the cases of Bernoulli-distributed (a la Glosten and Milgrom) and continuously distributed (a la Kyle) liquidation values, and focus on the latter case. In this case my model is able to explain the following features of stock returns: (i) Black's leverage effect (a.k.a. asymmetric volatility), (ii) persistent volatility, and (iii) more negative skewness for longer horizon returns. Model implications for price impact are as follows: (i) the impact has typically lower magnitude compared to the unconstrained case, (ii) the impact of extremely positive news has higher magnitude than the impact of extremely negative news, (iii) the impact of moderately positive news has lower magnitude than the impact of moderately negative news.

Financial distress, short sale constraints, and mispricing

This paper specifically examine how the extent of the distress puzzle differs according to the degree of mispricing and short sale constraints. We find that the distress puzzle observed for overpriced stocks, not for underpriced stocks, becomes insignificant after adjustment for short sale constraints due to an asymmetric pricing effect of short sale constraints only on the short-leg side of distress. However, after adjustment for arbitrage risk, the distress puzzle remains unchanged. These results indicate that the distress puzzle is mainly attributable to short sale constraints, rather than other limits-to-arbitrages such as arbitrage risk, which has a bi-lateral pricing effect on both short-leg and long-leg sides of distress. To mitigate a possible endogeneity problem relation among financial distress, mispricing, and short sale constraints, we measure these variables with different timing.

Breadth of Ownership and the Cross-Section of Corporate Bond Returns

We investigate the effects of short sale constraints on asset mispricing in the corporate bond market. Consistent with Miller (1977)’s theory that short sale constraints can lead to asset overpricing, we document a significant positive relation between changes in ownership breadth (a proxy for short sale constraints) and the cross-section of future corporate bond returns. The return predicative power of changes in breadth is shown to be relatively short-lived in the corporate bond market, possibly due to the bounded upside payoffs of debt. Further analysis shows that the return predictability of changes in breadth is stronger among bonds with higher credit risk and during periods of high investor sentiment, and is mainly driven by bond overpricing rather than underpricing. Overall, the impact of short sale constraints on bond mispricing appears to be more pronounced when overpricing is more likely.

Does Unconstrained Short Selling Result in Unbiased Security Prices? Evidence from the Weekend Effect in Futures Markets

Theoretical predictions and empirical results are ambiguous about the effect of short sale constraints on security prices. Since these constraints cannot be eliminated in equity markets, we use trades from futures markets where there is no distinction between short and long positions. We find that even with frictionless short selling, there is an upward bias in prices around weekends. The bias is stronger in periods of high volatility when short sellers are unwilling to accept higher levels of risk. On the other hand, riskiness of long positions does not seem to have a similar impact on prices. Thus, evidence in the paper shows that security prices may be biased upwards even without constraints on short selling due to asymmetric risk of short and long and positions.

Short-selling bans and institutional investors' herding behaviour: Evidence from the global financial crisis

The literature on short-selling restrictions focusses mainly on a ban's impact on market efficiency, liquidity and overpricing. Surprisingly, little is known about the effects of short-sale constraints on herd behaviour. Since institutional investors have come to dominate mature stock markets and rely extensively on short sales, constraining these traders may influence the asset pricing process. We investigate six stock markets that faced bans during the recent global financial crisis. Our empirical evidence shows that short-selling restrictions exhibit either no influence on herding formation or induce adverse herding. This implies a higher dispersion of returns around the market compared to rational asset pricing, which can be interpreted as an increase in uncertainty among stock market investors.

Short sale constraints, heterogeneous interpretations, and asymmetric price reactions to earnings announcements

This study tests Miller’s (1977) overpricing hypothesis from a new angle. Specifically, we investigate the effects of heterogeneous interpretations on price reactions to earnings announcements. We find that the difference between good news and bad news earnings response coefficients increases with the degree of heterogeneous interpretations in the presence of short sale constraints. This pattern is more pronounced when short sale constraints are more binding. These findings support the notion that, under short sale constraints, stock prices selectively incorporate more optimistic opinions rather than the average opinion of all investors. Therefore, reducing short sale constraints should facilitate price discovery and improve price efficiency. This study complements recent studies examining the joint effect of short sale constraints and ex ante opinion divergence on price reactions to earnings announcements.

Informed Short Sellers and Stock Price Reactions to Earnings Announcements: Evidence from China

Using the special event of short selling ban removal in the Chinese stock market in March 2010, I study the relationship between short selling activities and future stock returns and the effect of short sale constraints on stock price reactions to earnings announcements. I find strong evidence supporting the Diamond and Verrecchia (1987) hypothesis that an unexpected increase in short interest predicts negative future stock returns. The long-short portfolio that buys stocks with a decline or no change in short interest and shorts stocks with an increase in short interest is able to generate a significant positive return in the following week. The positive return is strongest during the first two days, is most significant in three industries: properties, conglomerates, and industrials, is highest for big firms, growth stocks, and stocks with high short interest. Moreover, I also confirm the Diamond and Verrecchia (1987) prediction that reducing short sale constraints leads to smaller price adjustments on the private information announcement day as the stock price reaction to earnings surprises on earnings announcement day is found to be 70% lower after the short sale ban is removed. However, I don’t find evidence supporting their prediction that the reduction in price reaction is larger when negative news is released due to data limitations.

Price Efficiency and Short Selling

This paper investigates the effect of short-sale constrain ts on price efficiency. We use a global dataset collected from several custodians, with over 85.7 million lending supply postings and 46.4 million lending transactions from January 2004 to June 2006. This information is available weekly for 17,015 stocks in 26 markets around the world. For each stock we estimate the supply of shares available for short-selling and the borrowing fee. Our main findings are as follows. First, shortsale constraints are associated with lower price efficiency . Stocks with limited lending supply and high borrowing fees respond more slowly to market wide shocks. Second, short-sale constraints affect the distribution of weekly stock returns. Limited le nding supply is associated with higher skewness, but not with fewer extreme negative returns. Third, stocks with limited lending supply and higher borrowing fees are associated with lower R 2 s on average. This finding challenges the claim that low R 2 s are associated with higher price efficiency.

The Impact of Short -Sale Restrictions on Volatility, Liquidity, and Market Efficiency: The Evidence from the Short-Sale Ban in the U.S.

On September 19, 2008 the Securities and Exchange Commission put a temporary ban on the short sales of 797 financial stocks. This unprecedented measure allows us to explore the impact of short-sale restrictions on the U.S. stocks. In this study we investigate the effect of short-sale constraints on volatility, liquidity and market efficiency. The results suggest there were statistically significant changes in liquidity, volume, and return volatility while the ban was in effect. We find that market liquidity deteriorated substantially, t quoted spread and percent quoted spread increased significantly, while turnover ratio, trading volume, and dollar volume declined during the ban. Furthermore, returns decreased and volatility of returns measured by squared returns increased during the restriction on shorting activity. Therefore, a significant drop in market efficiency is documented.

Effects of Short-Sale Constraints on Stock Prices and Trading Activity: Evidence from Hong Kong and Mainland China

There has been extensive literature on effects of short-sale constraints. A most widely study is Miller (1997) who argues that given the short-sale constraints, investors with bearish information cannot trade in the market unless they already hold the stocks. As a consequence, stock prices reflect opinion of optimistic investors, but not of all pessimistic investors. The effect of short-selling on overvaluation has received some empirical support in the U.S. market. The objective of this paper is to examine the effect of short-sale constraint on pricing efficiency in the China market. Not only that we provide additional evidence outside the U.S., the unique setting in the China market makes it an ideal laboratory experiment for providing direct evidence on the effect of short-sale constraint on the stock valuation. Many Chinese companies are dually listed in the Mainland and Hong Kong, either as A-shares listed in Shanghai or Shenzhen, or as H-shares in Hong Kong. Until now, all A shares are prohibited from short-selling. On the other hand, for those H shares which are listed in Hong Kong, some can be sold short and some cannot. This leads us to develop two hypotheses. The first is that the A-H premium is higher for those H share stocks subject to less short-selling restriction than for those subject to more restriction. The second is that the A-H volume ratio is lower for those H shares subject to less short selling restriction than for those subject to more restriction. We conduct empirical analysis using data on companies that are listed in both the A-share and H-share markets from 1996 to 2008, and provide evidence consistent with the two hypotheses.

Valuation Effects of Short Sale Constraints: the Case of Corporate Takeovers

Abstract We examine the relation between the degree of short sale constraints for acquiring firms' equity and post takeover stock performance. We find that negative long‐run abnormal returns appear to decline (in economic and statistical terms) as the extent and persistence of institutional block‐holder ownership increase, after accounting for the size, book‐to‐market and method of payment effects. In the spirit of Miller (1977), such evidence implies that the degree of short sale constraints serves as an important determinant of acquiring firms' short‐run overpricing. It appears that the presence of concentrated institutional presence mitigates and in most cases eliminates, through effective arbitrage, any short‐run overpricing that may be responsible for the long‐run underperformance of acquirers, preserving in this way efficiency in the takeover markets.