Short-sale Constraints Research Articles

Large-Scale Portfolio Allocation Under Transaction Costs and Model Uncertainty

We theoretically and empirically study large-scale portfolio allocation problems when transaction costs are taken into account in the optimization problem. We show that transaction costs act on the one hand as a turnover penalization and on the other hand as a regularization, which shrinks the covariance matrix. As an empirical framework, we propose a flexible econometric setting for portfolio optimization under transaction costs, which incorporates parameter uncertainty and combines predictive distributions of individual models using optimal prediction pooling. We consider predictive distributions resulting from highfrequency based covariance matrix estimates, daily stochastic volatility factor models and regularized rolling window covariance estimates, among others. Using data capturing several hundred Nasdaq stocks over more than 10 years, we illustrate that transaction cost regularization (even to small extent) is crucial in order to produce allocations with positive Sharpe ratios. We moreover show that performance differences between individual models decline when transaction costs are considered. Nevertheless, it turns out that adaptive mixtures based on high-frequency and low-frequency information yield the highest performance. Portfolio bootstrap reveals that naive 1=N-allocations and global minimum variance allocations (with and without short sales constraints) are significantly outperformed in terms of Sharpe ratios and utility gains.

Anomalies and Investor Sentiment: Empirical Evidences in the Brazilian Market

Abstract This study examined the relationship between investor sentiment and value anomalies in Brazil. In addition, it analyzed if pricing deviations caused by investors with optimistic views are different from those caused by pessimistic investors. The sample included all non-financial firms listed on the B3 (Brasil, Bolsa, Balcao) stock exchange from July 1999 to June 2014. We used the Principal Component Analysis multivariate technique to capture the component common to four different proxies for investor sentiment. The study empirically tested the index series and its variation on the return series of Long-Short portfolios of 12 anomaly-based strategies. The study found that the measure of the sentiment index had a partial explanatory power for the anomalies only when included in the CAPM. Yet, when using the index sentiment changes as an explanatory variable, the study found a relationship with future returns, robust to all risk factors. Thus, it is possible to relate investor sentiment index to anomaly-based portfolio returns. When analyzing average returns after optimistic and pessimistic periods, the values we found in our empirical test were not statistically significant enough to infer the possible existence of short-sale constraints.

Short Interest, Bearish Option Trades, and Short-Sale Constraints

Recent research has focused on the information content of short sales. In the plain vanilla capital asset pricing model, shorting a stock one thinks is priced too high is symmetrical with buying a stock one thinks is undervalued. However, there are several impediments to short selling in the real world that break the symmetry. A classic argument by Miller holds that when investors have heterogeneous beliefs about a stock but the market constrains short sales by the pessimists, the optimists will bid the price up too high and future returns will underperform. Because shorting is not actually prohibited, the question arises as to whether a stock with a relatively high level of short interest has a higher than average degree of latent pessimism (bad news for future returns) or, alternatively, is subject to no more negative beliefs than other stocks (no news) but has lower than average costs to short selling. Furthermore, the introduction of options trading creates alternative ways for investors with negative information to trade on their views by buying puts or writing calls. Du presents strong evidence supporting Miller’s argument and shows that high relative short interest is a signal of overpricing; high dispersion of opinion (as shown in earnings forecasts) and high short interest both are associated with overpricing and reinforce each other, and bearish option trades are a substitute for short sales.

Shortability and asset pricing model: Evidence from the Hong Kong stock market

Abstract This study explores how the violation of free short selling assumption affects the performance of CAPM and the Fama-French three-factor model, as existing studies show that short-sales constraints affect asset pricing of the stocks. Using data from the Hong Kong Stock Market which has unique regulations on short selling, we conduct both time-series and cross-sectional regression analyses to evaluate the performance of the two models under the short-sales-constraints and the no-constraints market environment. The two models perform much worse in the former environment than in the latter, indicating a significant impact of the short sales constraints on the explanatory power of the models. We then augment the two models with a shortability-mimicking factor. Our results show that the factor has a significant power in explaining both time-series and cross-sectional variation in the size-B/M portfolio returns. The addition of the factor to the two models considerably increases their overall performance.

Short Selling and Readability in Financial Disclosures: A Controlled Experiment

We examine the causal effect of short-selling on a firm’s annual report readability using Regulation SHO, which relaxes short-sale constraints for a random sample of pilot stocks. Pilot firms’ annual report readability decreases during the experiment period. This short-selling effect on 10-K readability is more pronounced for firms that receive less investor attention and for firms with worse news. Pilot firms also increase the use of uncertainty words in 10-Ks during the experiment period. Our results suggest that firms produce less transparent 10-Ks that are more costly for investors to comprehend when short-sale constraints are less rigorous.

Bank Capital and Bank Stock Performance

Little is known about how bank capital affects bank stock performance. We show that capital does not affect returns unconditionally, but high-capital banks have higher risk-adjusted stock returns (alphas) than low-capital banks in bad times in and out of sample. Trading strategies earn 3.60%–4.44% annually. The results are robust to: using different bad times and capital definitions, alternative asset pricing models, and ex-ante expected returns; controlling for performance-type delistings, short-sale constraints, and trading costs; and dropping the largest or smallest banks. Our results seem to be driven by a “Surprised Investor Channel” rather than by an “Informed Investor Channel.”

Short-Termist CEO Compensation in Speculative Markets: A Controlled Experiment

Bolton, Scheinkman, and Xiong (2006) model a setting where investors disagree and short-sales constraints cause pessimistic views of stock prices to be less influential, which leads to speculative stock prices. A theoretical implication of the model is that existing shareholders can exploit the speculative stock prices by: (1) designing managerial compensation contracts that encourage short-term performance, and (2) subsequently selling their shares to more optimistic investors. We document empirical support for this theory by finding that an exogenous removal (Regulation SHO) of short-sales constraints curbs the provision of short-term incentives, an effect reflected in longer CEO compensation duration. The effect is concentrated among stocks with high investor disagreement and short-term-oriented institutional ownership. Consistent with prior work, we also find that longer CEO compensation duration leads to longer CEO investment horizons, less over-investment, and less earnings management. Collectively, our results speak to the contributing role of speculative stock prices in corporate short-termism. Finally, our study implies that effective policies to curb corporate short-termism should address stock market speculation and promote mechanisms that tie executive compensation to longer-term stock price performance.

The Short Selling Regulation in the EU: Assessing the Authorization Granted for ESMA to Prohibit Short Selling

The paper discusses the renewed short selling regulation (Regulation (EU) No 236/2012) in the European Union. The focus is on the provisions that deal with prohibiting short selling in exceptional market circumstances. The Regulation further enforces certain obligations to report and disclose short positions. It is concluded that banning short selling is not an effective tool to contain extreme price volatility. The difference-in-differences regression and repeated measures GLM were used to test whether short selling bans were successful in containing volatility of those Spanish and Italian stocks that were subject to two back-to-back prohibitions during the years 2011-2013. The results are consistent with the majority of previous research, suggesting that the effectiveness of short sale constraints in reducing volatility is limited at best. Furthermore, there are evidence of counterproductive effects: constraints on short selling may actually increase volatility as well as deteriorate liquidity. However, based on theory and previous studies, reporting and disclosure requirements shall be favored provided they improve market efficiency as well as supervisory work of regulatory bodies.This paper discusses the renewed short selling regulation (Regulation (EU) No 236/2012) in the European Union. The focus is on the provisions that deal with prohibiting short selling in exceptional market circumstances. The Regulation further enforces certain obligations to report and disclose short positions. It is concluded that banning short selling is not an effective tool to contain extreme price volatility. The difference-in-differences regression and repeated measures GLM were used to test whether short selling bans were successful in containing volatility of those Spanish and Italian stocks that were subject to two back-to-back prohibitions during the years 2011-2013. The results are consistent with the majority of previous research, suggesting that the effectiveness of short sale constraints in reducing volatility is limited at best. Furthermore, there are evidence of counterproductive effects: constraints on short selling may actually increase volatility as well as deteriorate liquidity. However, based on theory and previous studies, reporting and disclosure requirements shall be favored provided they improve market efficiency as well as supervisory work of regulatory bodies. <w:LsdException Locked="fal

The dispersion anomaly and analyst recommendations

The main objective of this study is to distinguish whether the forecast dispersion anomaly is due to Miller’s (J Finance 32(4):1151–1168, 1977) overpricing hypothesis or idiosyncratic risk, by conditioning the sample on “buy” and “sell” consensus recommendations. Observations on the long and short possibilities provided to the investors by the analyst stock recommendations can help us infer on the impact of short sale constraints even though they are not directly observed. This study provides strong evidence that the impact of analyst forecast dispersion is more pronounced in the group of stocks that receive the least favorable recommendations in a given period, even after controlling for the idiosyncratic risk, Fama–French factors (J Financ Econ 33(1):3–56, 1993; J Financ Econ 116(1):1–22, 2015) and even short-sale constraints. These results are consistent with Miller’s (1977) hypothesis, according to which if short-sale constraints bind, high opinion divergence stocks become overpriced and hence have low subsequent returns.

Short sale constraints, dispersion of opinion, and stock overvaluation: Evidence from earnings announcements in China

Using a clean setting in China, we test the Miller (1977) hypothesis that stocks are overvalued in the presence of short sale constraints and dispersion of opinion as an extension of Berkman et al. (2009). We find that stocks with short sale constraints have significantly negative abnormal returns during earnings announcement periods, especially when investors have diverse opinions. These results are robust to alternative measures of abnormal returns and endogeneity concern. The findings help to explain the impact of short sale constraints on pricing efficiency and have important policy implications for relaxing restrictions on short selling and improving regular information disclosure in emerging markets.

Bubbles in the Australian housing market

This paper analyzes the evolution of Australian property prices, the relationships between cities, houses and units, the stock market and monetary policy. Using monthly house and unit prices for all eight capital cities we identify extended periods of explosive positive price changes followed by comparatively small corrections and no crashes. A comparison with Australian equity prices further reveals that the average risk and return are more favorable in the housing market emphasizing fundamental differences of the two markets such as liquidity and short-sale constraints. We also find evidence for financial contagion from the equity market to the housing market. A Vector Autoregression (VAR) shows that house price changes have a relatively strong effect on cash rate changes and thus monetary policy. The relative stability of Australian property prices over the last 20years suggests that policy makers played a role by providing an accommodating environment.

Is Short-Sales Constraint Really Significant in the Presence of a Centralized Lendable Stock Market?

Is Short-Sales Constraint Really Significant in the Presence of a Centralized Lendable Stock Market?

Differences in Expectations and the Cross Section of Stock Returns

We provide strong evidence that differences in expectations (DiE) among options investors, measured from the dispersion of equity options trading volume across moneyness levels, contain valuable information about future stock returns. Stocks with high DiE consistently underperform on average those with low DiE by more than 1% per month, with the negative DiE-return relationship strongest when short-sale constraints are high and among stocks that exhibit relatively high arbitrage risk. Moreover, we document that the DiE effect is highly persistent, pronounced in high sentiment periods, and is robustly distinct from a large array of previously documented cross-sectional return predictors.

A synthesized model of short selling constraints and their impact on stock returns

This paper presents a synthesized model explaining the returns of short-sale constrained stocks. We combine short-sale constraints that were previously treated individually or in pairs into a more fully specified model. The model is also specified in generally falling versus generally rising markets, and in consideration of relative effects for large/mid-cap versus small/micro-cap firms. There is evidence that a more fully specified model provides additional insight with less factor omission bias than prior models. Beyond that, our results indicate asymmetric pricing differences between least versus most short-sale constrained stocks, sensitive to overall market direction.

Sentiment and the Performance of Technical Indicators

This article studies the effectiveness of technical trading approaches in market environments of varying sentiment. Because of short-sale constraints, overpricing with high sentiment (i.e., relatively optimistic sentiment) is more prevalent compared to underpricing with low sentiment (i.e., relatively pessimistic sentiment), and this effect is stronger on difficult-to-arbitrage securities. The authors find consistent evidence over the period from 1993 to 2010 that the examined set of technical indicators perform better during periods of high sentiment than during periods of low sentiment. Moreover, this sentiment effect is relatively more pronounced for small stocks. These findings hold after a number of robustness checks are applied, and they highlight the importance of incorporating the sentiment effect when using technical indicators.

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.

Algorithm for Projecting Onto Simplicial Cones and Application to Portfolio Optimization

Many problems from diverse areas of research can be reformulated as the problem of computing the projection of a given vector in a Euclidean space onto the simplicial cone generated by a set of linearly independent vectors. For example, the well-known problem in finance of determining the minimum variance portfolio with no short sales constraint can be transformed to a problem of this type. Although the projection problem does not admit a solution in closed form, various numerical techniques have been proposed for its solution. This paper introduces an efficient new algorithm for the solution to this problem, and compares its performance to other algorithms proposed in the literature. It is shown that the algorithm is very efficient even for high dimensional problems, and orders of magnitude faster than methods introduced, for example, in Barrios, Ferreira and Nemeth (2015).

Option Trading Leverage and Stock Returns

Informed investors choose optimal leverage as a function of risk and cost. In the option market, they establish the chosen exposure using options of low leverage which are more liquid. On the other hand, noise traders prefer options of high leverage which have more lottery-like payoff. Such divergent preferences provide an opportunity to detect informed trading in the option market. In this paper I examine volume-weighted average of option leverage named Option Trading Leverage Ratio (OTLR). Portfolios with the lowest OTLR underperform portfolios with the highest OTLR by 1.28% monthly or 15% annually. Predicative relationship between OTLR and earnings-related information indicates that better skills in processing public information contributes to the advantage of informed option investors. Empirical findings are consistent with low OTLR capturing negative informed option trading due to the short-sale constraints of the stock market and liquidity concern of sophisticated investors. This paper contributes to the understanding of information flow in a multi-market environment.

A model for international capital markets closure in an economy with incomplete markets and short sales

Using a two-country dynamic optimization model, we investigate the impact of exchange risk, incomplete information and short sales constraints on international portfolio decisions around market closure. Using optimal control theory, we provide solutions and simulation results. Our model can be applied to solve several problems in financial economics in the presence of market closure, information asymmetry and short sales constraints.

The Impact of Short Selling and Margin Trading Regulation on Price Efficiency in China

We investigate the impact of short selling and margin trading on measures of price efficiency, characteristics of stock returns distributions, and price clustering in the Chinese equity market. Short selling and margin trading was permitted on selected stocks from March 31, 2010 and was subsequently extended to further securities in December 5, 2011. First, we find that the regulation change does not have a consistent impact on various price efficiency measures. Second, lifting short-sales constraints significantly reduces skewness. Third, the avoidance of numbers ending in 4, which is considered as unlucky, has marginally been reduced following the regulation change.