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Short-Sales Constraints and Price Discovery: Evidence from the ...

Short-Sales Constraints and Price Discovery: Evidence from the ...

1. IntroductionThe

1. IntroductionThe question of how short-sales practices impact capital markets is a highlycontroversial one, with short-sale regulations varying widely across countries andcapital markets. 1Whereas short selling has been carried out for years in majorfinancial markets around the world, its effects on market efficiency, especially onpricing efficiency, remain of interest to financial researchers.Miller (1977) theorizes that with short-sales constraints, security prices tend toreflect the most optimistic opinion and thus to be upward-biased. This overvaluationargument is based on two conditions: (1) security short sales are either prohibited orcostly and (2) investors have heterogeneous beliefs or information about the security’svalue. The underlying intuition is quite straightforward. Pessimistic investors areforced to sit out of the market when short sales are not available, and thus somenegative information is suppressed and not reflected in prices, enabling enthusiasticbuyers to bid prices above the level that average investors perceive as fair. Thisargument has a significant impact on market efficiency theories, since one of themajor functions of capital markets is price discovery, and an efficient market shouldbe “a market in which prices always ‘fully reflect’ available information” (Fama(1970).Jarrow (1980) and Figlewski (1981) are among those who initially attempted tomodel Miller (1977)’s idea rigorously in a static Capital Asset Pricing Modelframework. By providing a general equilibrium analysis, Jarrow (1980) shows that thetotal effect of prohibiting short sales may be more complex, owing to substitutioneffect among stocks. When two equivalent markets differing only with respect toshort-sales restrictions are compared, the price of an individual risky asset undershort-sales restrictions can be either higher or lower. Figlewski (1981) adopts astandard one-period model to show that when investors with unfavorable information1 Bris, Goetzmann, and Zhu (2003) provide a comprehensive review of the regulations of short sales in 47 equitymarkets around the world.- 1 -

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