Short-sale Constraints Research Articles

Do short-sale constraints inhibit information acquisition? Evidence from regulation SHO

We investigate how short-sale constraints influence investor information acquisition. Leveraging the U.S. Securities and Exchange Commission's (SEC's) Regulation SHO pilot program, we find that relaxed short-sale constraints lead to increased public information acquisition by investors. Investors acquire and process valuable information and utilize it to improve their short-selling decisions after the relaxation of short-sale constraints. We obtain similar findings using a quasi-natural experiment in China that lifted short-sale bans, supporting the external validity of our results. Collectively, our evidence demonstrates that reduced trading frictions promote information acquisition and contribute to price discovery.

Mispricing and Anomalies: An Exogenous Shock to Short Selling from JGTRRA

We investigate the causal impact of short-sale constraints on market anomalies by analyzing a comprehensive set of 182 anomalies. Our approach leverages a persistent, robust, and plausibly exogenous shock to short-selling supply caused by the dividend tax law change in the Job and Growth Tax Relief Reconciliation Act (JGTRRA) of 2003. Our findings reveal that anomalies decline after JGTRRA. However, this tax law change impedes arbitrageurs’ ability to correct mispricing, resulting in anomalies decaying less following dividend record months compared to other months post-JGTRRA. Furthermore, this effect is concentrated on overpriced stocks as opposed to underpriced stocks. Interestingly, while this shock significantly affects most types of anomalies, valuation anomalies remain unaffected.

Sentiment and information: How ‘over-optimistic’ investors influence differences of opinion and IPO pricing?

Miller (1977) predicts that under short-sale constraints, when emotional investors gain stronger bargaining power relative to rational investors, disagreement among investors widens, leading to overvaluation of IPOs. With a difference-in-differences model, we find that the 2021 reform of China's inquiry system expanded investor disagreement due to the introduction of overly optimistic investors, resulting in overvaluation of IPOs and poor initial returns. Influenced by overly optimistic investors, rational investors experience a partial increase in information levels, generating a masking effect in the emotional impact chain. Our study supports Miller's hypothesis, contributing to understanding the roles of ‘emotion’ and ‘information’ in shaping disagreement and enhancing IPO pricing efficiency.

Policy uncertainty, bad news disclosure, and stock price crash risk

This paper documents that economic policy uncertainty reduces future stock price crash risk by increasing firms’ disclosure of bad news. Our tests show that firms release more bad news during periods of high policy uncertainty – they use more conservatism accounting, exhibit stronger future earnings response coefficients, use more negative tones in their financial reports, and have managers that express more negative sentiment in earnings conference calls than during periods of low policy uncertainty. Additional analyses show that the negative relation between EPU and future stock price crash risk is more pronounced among firms with more short-sale constraints, with no actively traded credit default swap contracts, with lower options-implied negative skewness, or with higher firm-level political risks. The results from regressions adopting the instrumental variable approach and from a quasi-natural experiment suggest that the negative relation observed between policy uncertainty and stock price crash risk is unlikely to be driven by potential endogeneity.

On bankruptcy in general equilibrium with uncertainty

In a general equilibrium model with time and uncertainty the possibility of bankruptcy cannot be excluded in general, when short sale constraints are too loose. Tight short trading constraints, on the other hand, are inefficient. Bankruptcies turn security payoffs endogenous and destroy convexity of the induced preferences over portfolios. The latter raises existence issues for competitive equilibrium, as illustrated in this paper by an example.

Strategic borrowing from passive investors

Abstract We find that short sellers manage risks by strategically borrowing shares in stocks with significant ownership by passive investors. This practice increases securities lending demand for stocks with substantial passive ownership, resulting in improved price efficiency, higher lending fees, and increased short interest in these stocks. Consistent with the risk mitigation motive, these stocks show reduced risks of unexpected fee hikes and loan recall, longer loan durations, and attract more informed short sellers. These effects are particularly pronounced in hard-to-borrow stocks where short-sale constraints are binding. Our study suggests that passive investing helps alleviate short-sale constraints by reducing the risks associated with stock borrowing.

Tail risk aversion and backwardation of index futures

We show that tail risk aversion, proxied by the skewness risk premium implied from the SSE 50 ETF options market, explains a significant proportion of the unusually deep backwardation of index futures during the 2015 Chinese stock market crash, while traditional factors such as non-synchronous trading, spot return, volatility and liquidity, all fail to explain the backwardation. These empirical results imply that investors' concern over the crash risk causes speculators to charge a high ‘insurance premium’ on hedgers. On the other hand, short-sale constraints, namely high security borrowing costs and other barriers, prevent reverse arbitrage such that the deep backwardation of index futures persists.

Options trading imbalance, cash-flow news, and discount-rate news

Using publicly available information on option volume totals, we develop new measures of directional option-to-stock (O/S) trading volume imbalance. The novel measures are strongly related to the cash-flow (CF) and discount-rate (DR) news components of unexpected stock returns and consistently predict future abnormal performance. While options markets respond more strongly to CF news than do equity markets, they still do not fully incorporate CF news into prices and therefore lead to returns predictability. This underreaction phenomenon is of smaller magnitude when the options market response is stronger and when short-sale constraints are less binding.

How Much Can Machines Learn Finance from Chinese Text Data?

How much can we learn finance directly from text data? This paper presents a new framework for learning textual data based on the factor augmentation model and sparsity regularization, called the factor-augmented regularized model for prediction (FarmPredict), to let machines learn financial returns directly from news. FarmPredict allows the model itself to extract information directly from articles without predefined information, such as dictionaries or pretrained models as in most studies. Using unsupervised learned factors to augment the predictors would benefit our method with a “double-robust” feature: that the machine would learn to balance between individual words or text factors/topics. It also avoids the information loss of factor regression in dimensionality reduction. We apply our model to the Chinese stock market with a large proportion of retail investors by using Chinese news data to predict financial returns. We show that positive sentiments scored by our FarmPredict approach from news generate on average 83 basic points (bps) stock daily excess returns, and negative news has an adverse impact of 26 bps on the days of news announcements, where both effects can last for a few days. This asymmetric effect aligns well with the short-sale constraints in the Chinese equity market. The result shows that the machine-learned prediction does provide sizeable predictive power with an annualized return of 54% at most with a simple investment strategy. Compared with other statistical and machine learning methods, FarmPredict significantly outperforms them on model prediction and portfolio performance. Our study demonstrates the far-reaching potential of using machines to learn text data. This paper was accepted by Kay Giesecke, finance. Funding: This study was supported by the National Natural Science Foundation of China [Grants 71991471, 71991470, and 72204049], the National Key Research and Development Program [Grant 2020YFA0608604], the Shanghai Pujiang Scholar Project [Grant 21PJC010], the Shanghai Science Project [Grant 23692119300], and the China Postdoctoral Science Project [Grants 2019M650076 and 2020T130107]. Supplemental Material: The online appendix and data files are available at https://doi.org/10.1287/mnsc.2022.01468 .

Short-sale constraints and stock returns: a systematic review

PurposeThis study delves into the nuanced implications of short-sale constraints on stock prices within the context of stock market efficiency. While existing research has explored this relationship, inconsistencies persist in their findings. The purpose of this study is to conduct a comprehensive review of literature to elucidate the reasons behind these disparities.Design/methodology/approachA systematic review of existing theoretical and empirical studies was conducted following the PRISMA method. The analysis centered on discerning the factors contributing to the divergence in projected stock prices due to these constraints. Key areas explored included assumptions related to expectations homogeneity, revisions, information uncertainty, trading motivations and fluctuations in supply and demand of risky assets.FindingsThe review uncovered multifaceted reasons for the disparities in findings regarding the influence of short-sale constraints on stock prices. Variations in assumptions related to market expectations, coupled with fluctuations in perceived information uncertainty and trading motivations, were identified as pivotal factors contributing to differing projections. Empirical evidence disparities stemmed from the use of proxies for short-sale constraints, varied sample periods, market structure nuances, regulatory changes and the presence of option trading.Originality/valueThis study emphasizes the significance of not oversimplifying the impact of short-sale constraints on stock prices. It highlights the need to understand these effects within the broader context of market structure and methodological considerations. By delineating the intricate interplay of factors affecting stock prices under short-sale constraints, this review provides a nuanced perspective, contributing to a more comprehensive understanding in the field.

Navigating Uncertainty: Enhancing Markowitz Asset Allocation Strategies through Out-of-Sample Analysis

This research paper explores the complicated connection between uncertainty and the Markowitz asset allocation framework, specifically investigating how mistakes in estimating parameters significantly impact the performance of strategies during out-of-sample evaluations. Drawing on relevant literature, we highlight the importance of our findings. In contrast to common assumptions, our study systematically compares these approaches with alternative allocation strategies, providing insights into their performance in both anticipated and real-world out-of-sample events. The research demonstrates that incorporating methods to address uncertainty enhances the Markowitz framework, challenging the idea that longer sample periods always lead to better outcomes. Notably, imposing a short-sale constraint proves to be a valuable strategy for improving the effectiveness of the initial portfolio. While revealing the complexities of uncertainty, our study also highlights the surprising resilience of basic asset allocation approaches, such as equally weighted allocation, which exhibit commendable performance. Methodologically, we employ a rigorous out-of-sample evaluation, emphasizing the practical implications of parameter uncertainty on asset allocation outcomes. Investors, portfolio managers, and financial practitioners can use these insights to refine their strategies, considering the dynamic nature of markets and the limitations internal to the traditional models. In conclusion, this paper goes beyond the theoretical scope to provide substantial value in enhancing real-world investment decisions.

Short Squeezes

We investigate the prevalence and persistence of short squeezes and the corresponding economic consequences on the stocks being squeezed. Using daily short sale data, we provide evidence that a short squeeze on average subsides within seven trading days and can be driven by both the capital constraint of the short sellers and the short sale constraint of the underlying stocks. The risk of being squeezed is higher during major macroeconomic events. Further analyses reveal that squeezed stocks experience an increase in the demand for and the cost of borrowing the shares and in trading volume, idiosyncratic volatility, and abnormal returns.

Factor momentum in the Chinese stock market

Based on 10 commonly used factors, we construct a novel factor momentum strategy in the Chinese stock market, which earns an annualized return of 9.91 %, with a Sharpe ratio of 1.15. Factor momentum subsumes stock momentum, high-priced momentum, and industry momentum, digests its component factors and a variety of anomalies, and represents the momentum anomaly in China. Furthermore, mispricing correction helps explain factor momentum, which produces stronger returns during higher aggregate idiosyncratic volatility periods as well as among stocks with higher information asymmetry and short-sale constraints. Exposure to factor premiums and the manifestation of predictability determine factor momentum in China.

Investors' opinion disagreement and abnormal trading around pre-earnings announcements

We use textual analysis techniques to construct a direct measure of investor disagreement to explain the abnormal stock volume and return around earnings expectation announcement in China. We crawl scrape the most a popular Chinese stock forum for individuals' posts about their opinion on a stocks, and classify the posts with machine learning methods. We find that our measure is most correlated with return volatility and historical turnover. We then conduct an event study for abnormal stock volume around pre-earnings announcements, examining the cumulative abnormal turnover for sample groups with prior agreement or disagreement, and with a convergence or divergence of opinion. We find that given prior disagreement of opinion, both convergence and divergence of opinion causing more trading volume in the Chinese market. We also observe the sample group with a divergence of opinion has more cumulative abnormal return than the convergence group. However, this effect is found to be more profound in stocks with higher institutional ownership, which is believed to be correlated with a low short-sale constraint.

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 .

Short-sale constraints and firm investment efficiency: Evidence from a natural experiment

We examine the causal effect of relaxing short-sale constraints on firm investment efficiency using the experiment of the SEC Regulation SHO pilot program. Using a difference-in-differences approach, we find significant treatment effects of the pilot program on mitigating both underinvestment and overinvestment during the pilot period. These treatment effects disappear after the end of the pilot program. The effect on mitigating underinvestment is stronger for firms with severe financial constraints before the pilot period. The pilot program mitigates underinvestment and alleviates financing constraints more for pilot firms that experienced greater improvement in price efficiency after the pilot program began. The effect of the pilot program on mitigating overinvestment is more pronounced for firms with weaker governance and firms with more severe agency problems before the pilot period. These results suggest that relaxing short-sale constraints mitigates underinvestment through the external financing channel by improving price efficiency that alleviate financial constraints; and mitigates overinvestment through the managerial incentive channel by strengthening the disciplinary role of short sellers that enhances managers’ incentives to take correct actions.

How price limit affects the market efficiency in a short-sale constrained market? Evidence from a quasi-natural experiment

In this paper, we examine the joint effect of price limit and short-sale constraints on price discovery. Using a natural experiment in China, we show the exogenous relaxation of price limit improves price efficiency. Importantly, shortable stocks experience more improvement in price efficiency than non-shortable stocks. Event-study analysis further documents less delayed price discovery following the price-limit-hitting event on shortable stocks, which is explained by selling pressure from large institutional orders. Our findings suggest that alleviating shortsale constraints could synergize with the relaxation of trading restrictions to improve price efficiency.

The Impact of Derivatives on Spot Markets: Evidence from the Introduction of Bitcoin Futures Contracts

Cryptocurrencies provide a unique opportunity to identify how derivatives impact spot markets. They are fully fungible and trade across multiple spot exchanges at different prices, and futures contracts were selectively introduced on Bitcoin (BTC) exchange rates against the U.S. dollar (USD) in December 2017. Following the futures introduction, we find a significantly greater increase in cross-exchange price synchronicity for BTC–USD relative to other exchange rate pairs as demonstrated by an increase in price correlations and a reduction in arbitrage opportunities and volatility. We also find support for an increase in price efficiency, market quality, and liquidity. The evidence suggests that futures contracts allowed investors to circumvent arbitrage frictions associated with short-sale constraints, arbitrage risk associated with block confirmation time, and market segmentation. Overall, our analysis supports the view that the introduction of BTC–USD futures was beneficial to the Bitcoin spot market by making the underlying prices more informative. This paper was accepted by Will Cong, Special Section of Management Science: Blockchains and Crypto Economics. Funding: The authors acknowledge financial support from the Global Risk Institute. P. Augustin acknowledges financial support from the Canadian Derivatives Institute and from the Canada Research Chair Program of the Social Sciences and Humanities Research Council Canada. The paper has benefited significantly from a fellow visit of P. Augustin at the Center for Advanced Studies Foundations of Law and Finance funded by the German Research Foundation, project FOR 2774, and from a visiting position of P. Augustin at the finance department of the University of Luxembourg facilitated through the Inter Mobility Programme of the Luxembourg National Research Fund. Supplemental Material: The online appendix and data are available at https://doi.org/10.1287/mnsc.2023.4900 .

Liquidity spillover between ETFs and their constituents

ETF sponsors promote ETFs as having superior liquidity than their constituents because they possess two layers of liquidity-the market liquidity of ETFs and the underlying stocks' liquidity. We find a liquidity connection between the ETF and its underlying stocks, suggesting the potential simultaneous liquidity dry-up in both markets. Liquidity spillovers increase during the market crisis, and economic downturns and are positively related to market volatility and funding constraints. Besides, a stock with high volatility and low trading activity exhibits higher liquidity spillover. Finally, liquidity spillover varies proportionally with ETF arbitrage activity and tends to be lower when short sales constraints exist.