Short Sale Restrictions Research Articles

Performance Sharing in Risky Portfolios: The Case of Hedge Fund Returns and Fees

Institutional investors face various leverage and short-sale restrictions that alter competition in the asset management industry. This distortion enables unconstrained investors with high volatility targets to extract additional income from constrained institutional investors. Using a sample of 1,938 long–short equity hedge funds spanning 15 years, the authors show that high-volatility funds charge higher fees and deliver lower net-of-fees Sharpe ratios than do their low-volatility peers. This evidence could be interpreted as a situational rent extraction or as a service compensation. Conversely, increased volatility could result from a manager’s ambition to deliver large net information ratios after accounting for a high fee structure.

The relationship between herding behavior and firm size before and after the elimination of short-sale price restrictions

The present paper investigates the relationship between investor herding behavior and stock return under short-sale price restrictions. Detailed intra-day orders are applied to calculate herding measurements before and after a staged lifting of short-sale restrictions on May 16th, 2005 and September 23rd, 2013 in Taiwan. The former targeted the constituent stocks of the Taiwan 50 Index only, while the latter targeted all listed firms on the Taiwan Stock Exchange. Using the Chow test and the dynamic structural change point test to confirm the effect of ending these restrictions, the results found that short-sale restrictions increased individual herding behavior in the context of the stocks of small firms, especially those stocks in the low quantile of stock returns. Conversely, herding behavior was not shown to significantly impact the stock returns of large firms either before or after the end of short-sale price constraints for either individual or institutional investors.

Arbitrage Opportunities: Anatomy and Remediation

We introduce an experimental design where arbitrage opportunities emerge reliably and repeatedly. We observe significantly higher sell-side than buy-side arbitrage opportunities. We study ways to mitigate them. Relaxing margin requirements, shortsale restrictions, or both have neither statistically nor economically significant effects. Increasing competition (more participants, each with small stakes), and more impactful, participants’ stakes (few wealthy participants each with large exposures), generate large reductions in arbitrage opportunities. Hence, we advocate increased competition for small markets, and allowance for large stakes in large markets, rather than relaxation of rules on margin purchases or shortsales.

Preferences for lottery stocks at Borsa Istanbul

We investigate the existence of lottery-like preferences of investors at Borsa Istanbul. Proxying these preferences with demand for stocks with extreme positive returns (“MAX”), we establish that high-MAX stocks’ significantly underperform low-MAX stocks, controlling for a series of potential explanatory return characteristics. We find that the negative relationship between MAX and expected returns is driven by stocks strongly preferred by individual investors and strengthens following periods of high investor sentiment. A natural experiment suggests that the MAX discount increased during the period of temporary short-sale restrictions at Borsa Istanbul. Our findings suggest a limits-to-arbitrage explanation for the MAX anomaly.

Public news announcements, short-sale restriction and informational efficiency

In this paper, we address the question that with differences in opinion in reality, how quickly stocks incorporate news shocks when they are subject to different levels of short-sale constraints. Specifically, we examine the impact of short-sale restriction on stock price efficiency when firms make public earnings announcements. Using data from the Hong Kong stock market, where some stocks are eligible for and others are prohibited from short selling, we find significantly lower post-announcement returns with high economic magnitude for short-sale prohibited stocks with both positive and negative news shocks. The reduction in informational efficiency due to short-sale restriction persists several months after the earnings announcement. The informational inefficiency due to short-sale restriction is particularly severe for firms with negative announcement period shocks and subject to greater differences in opinion.

Thriving in a disrupted market: a study of Chinese hedge fund performance

We study a group of newly-emerged hedge funds in China, focusing on their performance and growth under a series of recent regulatory changes. These include the implementation of short sale restrictions and a circuit breaker. We find that the funds in our sample generally outperformed the stock market despite these regulatory disruptions. The best-performing equity-related strategies were long-short and multiple strategies. Our results indicate that the ability to sell short is important for all funds adopting equity-related strategies other than the long strategy. The imposition of short sale restrictions significantly reduced hedge fund performance, and the performance differential between “winner” and “loser” funds converged over time. The evidence suggests that the regulatory changes have greatly affected the hedge fund industry in China.

A CAPM WITH TRADING CONSTRAINTS AND PRICE BUBBLES

This paper derives an equilibrium capital asset pricing model (CAPM) in a market with trading constraints and asset price bubbles. The asset price processes are general semimartingales including Markov jump-diffusion processes as special cases, and the trading constraints considered include short sale restrictions, borrowing constraints, and margin requirements, among others. We derive a generalized intertertemporal CAPM and consumption CAPM for these markets. The implications for empirical testing are that additional systematic risk factors will exist in a market with trading constraints and price bubbles as contrasted with an otherwise equivalent unconstrained market with no price bubbles.

Does short sale restriction lower price efficiency when substitutes exist? Evidence from the Korean market

Using KOSPI200 index options, futures, and warrants, this study examines the effect of short sale restriction on price efficiency by circumventing the concerns regarding firm characteristics, market conditions, and limited information acquisition of investors in previous empirical studies. This study finds that warrants are as price efficient as other derivatives products after market conditions are considered, even though warrant investors cannot short sell. This finding provides an example that short sale restriction on some assets may not hinder market efficiency if there are close substitutes for those assets in the market.

An Equilibrium Capital Asset Pricing Model in Markets with Trading Constraints and Price Bubbles

This paper derives an equilibrium capital asset pricing model (CAPM) in a market with trading constraints and asset price bubbles. The asset price processes are general semimartingales including Markov jump-diffusion processes as special cases, and the trading constraints considered include short sale restrictions, borrowing constraints, and margin requirements, among others. We derive a generalized intertertemporal CAPM and consumption CAPM for these markets. The implications for empirical testing are that additional systematic risk factors will exist in a market with trading constraints and price bubbles as contrasted with an otherwise equivalent unconstrained market with no price bubbles.

Are all insiders on the inside? Evidence from the initiation of CDS trading and short selling in the financial sector

We examine the impact of CDS trading and the lifting of short sales restrictions on the profitability of reported insider trades within US financial firms. We find evidence that executive directors possess significant insider knowledge about their firm’s risk prior to the initiation of CDS trading. We also find that the profitability of insider trades are only reduced for non-executive directors after short selling is permitted, indicating that the executive directors possess more timely private information than short-sellers. Our results suggest that the introduction of CDS trading and short selling distinctly alters the ability of different types of insiders to extract rent on their private information.

The Systematic Risk of Short-Sale Restrictions

In finance literature it is known that on a financial market in which short-selling of risky assets is restricted, the market portfolio is typically not efficient (see e.g. Fama and French (2004)). This paper analyses two different kinds of regulatory policies of short-sales on financial markets in which asset returns are given by an exogenously generated stochastic process. The first constraint allows investors short-selling of a reasonable size whereas the second prohibits short-selling of any size. For both policies a modified market portfolio is introduced. These portfolios are mean-variance efficient with the highest possible Sharpe ratio and satisfy the corresponding short-sale constraint. For both cases a time-dependent security market line is implemented which allows for a decomposition into systematic and non-systematic risk. It is shown that, from a viewpoint of a regulator, the restricted short-sale constraint is a more suitable regulatory policy. In contrast to the prohibited short-sale constraint, the restricted short-sale constraint, does not reduce the possibility of diversification. Hence, the portfolio return in this case has no diversifiable risk, a higher Sharpe ratio and a smaller coefficient of variation, which yields a smaller default risk, provided the return process is multivariate elliptically distributed.

Are All Insiders on the Inside? Evidence from the Initiation of CDS Trading and Short Selling in the Banking Sector

We examine the impact of CDS trading and the lifting of short sales restrictions on the profitability of reported insider trades within US financial firms. We find evidence that executive directors possess significant insider knowledge about their firm’s risk prior to the initiation of CDS trading. We also find that the profitability of insider trades are only reduced for non-executive directors after short selling is permitted, indicating that the executive directors possess more timely private information than short-sellers. Our results suggest that the introduction of CDS trading and short selling distinctly alters the ability of different types of insiders to extract rent on their private information.

Impact of short selling restrictions on informed momentum trading: Australian evidence

We examine the impact of short selling restrictions on the momentum strategy returns of Australian equities during the Global Financial Crisis (GFC). Momentum strategy is based on a long position in a winner portfolio comprising of the previous 10% best-performing stocks and a short position in a loser portfolio comprising of the previous 10% worst-performing stocks. We find that momentum strategy during the GFC are less profitable compared to the pre-GFC period. Momentum returns are negatively correlated to the short sales restrictions, and that loser portfolios rather than winner portfolios drive this result. These momentum returns are robust to transaction costs and liquidity effects. An explanation is that the imposition of the short selling restrictions by the Australian Securities and Investments Commission from September 2008 to May 2009 may have moderated the ability for momentum traders to profit from the short sale of loser portfolios. However, informed momentum profits are attributable to the loser portfolio across the holding periods of 3 to 12months, which implies that informed institutional traders take advantage of their private information to overcome adverse selection costs. This enables them to short sell their loser portfolios and carry out their momentum trading strategies.

The effect of short-sale restrictions: another perspective

Purpose The purpose of this paper is to examine the effect of short-sale restrictions (SSR) with particular emphasis on their impact on the liquidity and informed trading in the stock and option markets. Design/methodology/approach Using a panel regression with controls for volatility, VIX and matched stocks, this study examines the effect of the short-sale ban (SSB) on stock and option liquidity, expressed in terms of spread and volume. In addition, the PIN and option information share (OIS) measures have been used to analyze its impact on informed trading in those related markets. Findings The results suggest that the SSB leads to a significant reduction in the liquidity of the affected stocks and their options. However, no significant change in the trader composition can be detected. This result is consistent to the short-prohibition effect predicted by Diamond and Verrecchia (1987). Research limitations/implications Due to the sizeable data required to estimate the PIN and OIS measures, only a select sample of optionable stocks has been examined. Originality/value This study offers both academics and policy makers some useful insights into the effect of SSR on trading activities in both stock and option markets. From a policy perspective, it clearly demonstrates that regulatory changes targeting a specific market also affect other related markets via the arbitrage link between them.

Short Selling Ban and Its Impact to Stock Market

Most of the financial regulators around the world such as ASIC, FSMA, CSRC, AMF, FFSA, FCA, SEC reacted to the 2007-09 turmoil and 2011 Greek debt crisis by imposing short sales restrictions. These series of events held and elevated at different dates and in different nations based on various sets of stocks featuring degree of severity. This paper examined several findings of research on shorting bans and its impacts to the security market in different aspects such as stock price and its behavior during ban, price discovery and the liquidity. It is also found that during the ban, activity related to shorting dropped by 77% and smallest stocks that was related to the ban underwent severely in market quality based on spreads, intraday volatility and price impacts. Those stocks, which are listed, did not provide any price impact but during the whole banning period it was underperforming constantly. Evidences portrays that the shorting ban did not generate any simulated improve in prices.

Pricing derivatives in the presence of shadow costs of incomplete information and short sales

Financial models are based on the standard assumptions of frictionless markets, complete information, no transaction costs and no taxes and borrowing and short selling without restrictions. Merton’s (J Finance 42:483–510, 1987) develops a simple model of capital market equilibrium with incomplete information. Wu et al. (Rev Quant Finance Account 7:119–136, 1996) extend Merton’s (J Finance 42:483–510, 1987) model by proposing an incomplete information capital market equilibrium with heterogeneous expectations and short sale restrictions, GCAPM. The shadow costs include two components. The first component is the product of pure information cost due to imperfect knowledge and heterogeneous expectations. The second component represents the additional cost caused by the short-selling constraint. Short-selling bans around the world after the global financial crisis become more and more important. Nezafat and Wang (Short-sale constraints, information acquisition, and asset prices, Scheller College of Business, Georgia Institute of Technology, Atlanta, p 30308, 2013) develop a model of information acquisition and portfolio choice under short-sale constraints. Bellalah (J Futures Mark, 1999) and Bellalah and Wu (Ann Oper Res 165:123–143, 2009) include information costs the valuation of assets and derivatives. This is the first study to our knowledge devoted to the pricing of derivatives that accounts simultaneously for information costs and short sales constraints for the option market and its underlying asset market. We extend the classic models by Black and Scholes (J Polit Econ 81:637–659, 1973), Black (J Financ Econ 79(3):167–179, 1976), and Barone-Adesi and Whaley (J Finance 2(81):303–320, 1987) among others to account for shadow costs of incomplete information and short sales. We present a general method and provide the general differential equation for the pricing of derivatives within incomplete information and short selling costs.

The SEC's Busted Randomized Experiment: What Can and Cannot Be Learned

During 2005-2007, the US Securities and Exchange Commission ran a randomized experiment, in which it removed short sale restrictions for some “treated” firms, chosen at random, and left these restrictions in place for others. The SEC experiment has been exploited by many finance and accounting scholars, who report evidence that removing short sale restrictions affected a wide range of financial outcomes, including share prices, firm investment strategy, accounting accruals, auditor behavior, innovation, and much more. We show that the SEC busted its own randomization experiment, in a way which undermines most prior studies. The SEC in fact conducted three distinct randomized experiments; these can be examined separately but cannot be combined without further, likely unjustified assumptions. We discuss what one can and cannot learn from these three experiments. We also develop reasons and supporting evidence for why relaxing short-sale restrictions was unlikely to affect most of the outcomes studied in recent work. We explain the need, when studying the indirect effects of the SEC experiment, to account for nonrandom choices by short sellers on which firms to “target”, and the nonrandom responses of firm managers and other market participants to removal of short sale restrictions. We then revisit selected results from prior studies (effect of the experiment on open short interest and share prices), and find no evidence that the relaxing short-sale restrictions affected either measure.

Bullish/bearish/neutral strategies under short sale restrictions

Abstract This study investigates the effects of short sale restrictions by extending the model of Dridi and Germain (2004) and infers informed traders’ strategies and the relation between order imbalance and price thereunder. The results are generally in line with the empirical evidence documented in the literature and are summarized as follows: First, seller-initiated trading incurs a greater price reaction. Second, short sale restrictions shift the skewness of asset returns. Third, the restrictions can stimulate investors to acquire information or increase each individual trader's order flow under the bullish and neutral signals as well as the bearish signal, which is yet to be explored empirically.

Post-Holiday Drift, Sentiment and Short-Sale Restriction: Evidence from AH Cross-Listed Stocks

This paper investigates whether non-overlapping trading time between two markets can cause return predictability from one market to another. We select cross-listed stocks in mainland China and Hong Kong. A weak return predictability is found in short horizon but no predictability exists in long period. We study two potential factors that may moderate the predictability power: sentiment and short-sale restriction. We find that (1) the return predictability in high sentiment period is stronger than that during low sentiment period; (2) the return predictability, especially in the short-leg portfolio, is increased when trading is restricted by short-sale restriction.

Prospect theory and portfolio selection

We examine prospect theory portfolios in asset allocation settings that include riskfree lending and borrowing, subject to margin constraints, and short sales restrictions on risky assets. In static settings, we focus on myopic loss aversion, which assumes loss averse investors are willing to take more risk if they evaluate their investment performance infrequently. The results show the portfolios, including those of the investor with a loss aversion coefficient of 2.25, are extremely unstable across decision horizons. In dynamic settings, the portfolios of investors with loss aversion on the order of two perform well. But in some instances the house money effect, where the position of the kink and the investor’s loss aversion changes with gains and losses, has a large negative impact on the wealth of these investors.