Ebook Dynamic Short'Sales Constraints, Price Limits and Price Delays
Imposing some form of short'sales constraints is a common response of regulators facing stock market downturns. The latest example is the global restrictions on short'selling in September/October 2008 due to the credit crunch. Although widely adopted, the impact of short'sales constraints on stock prices is still debated. Miller (1977) argues that if short' sales constraints are imposed, stock prices are set only by optimistic investors and these stocks are thus overpriced. With a rational expectation model, however, Diamond and Verrecchia (1987) argue that short'sales constraints do not necessarily bias prices upward. Investors rationally incorporate the constraints into prices. Bai, Chang and Wang (2006) take the rational expectation model one step further. They argue that risk averse investors ask a higher premium as compensation for bearing more risk due to less informative trades. In this paper, we shed light on the theories by providing a unique empirical strategy to study the effect of short'sales constraints on the prices.
We take advantage of a natural experiment in the Taiwan stock market. On 4th of September 1998, the Taiwanese Securities and Futures Bureau prohibited investors from short'selling a stock at a price below its close price of the previous trading day. It was a stability measure for the aftermath of the Asian financial crisis. The spirit of the rule is similar to the U.S. uptick rule since both try to prevent short'sellers from driving stock prices further downward. The major difference is that the rule in Taiwan is stricter and clearer. Unlike the multiple reference prices in the uptick rule, there is only one price (determined and fixed before the market opening) in Taiwan per day. Therefore, investors are aware of whether short'selling is banned or not during the trading hours. Consequently, this rule creates daily dynamics of short'sales constraints.
These dynamic constraints are ideal for testing the different implications of the theories. The theory of Miller (1977) implies that stocks are overpriced when short'selling is not feasible during trading hours and will be corrected after the restriction is lifted. Hence, we should see lower return following a constrained day. Diamond and Verrecchia (1987) argue that investors know that the short'sellers are excluded from the market during the constrained day. They rationally would incorporate it into prices, which on average would then be at the right level. Thus the returns would not be affected by the constraints. Investors in Bai et al. (2006) ask for an extra premium because of the information uncertainty in the market due to the absence of the short'sellers. Hence, stock prices could be on average too low during a ban day and will bounce back after the ban is lifted. These three models thus imply a positive, zero and negative price delay (or auto correlation) in stock prices respectively.
Our main contribution is to evaluate the influence of these dynamic short'sales constraints on stock price delays. Using these constraints has several advantages over the existing proxies discussed below. First, the dynamic constraints are imposed by the regulators rather than determined by the lending supply and demand. This specific feature alleviates the concern of endogeneity or reverse causality. This is because the tightness of the constraints is not related to firm specific characteristics, which might also affect the lending market equilibrium. In addition, for rational expectation to work, investors have to be clearly aware of the tightness of the constraints to incorporate them into the prices. In contrast to the lending market data, our dynamic constraints are observed by all investors and thus provide an ideal environment to test the implications. Second, unlike a one time only natural experiment, the daily constraints are spread across stocks and different points in time for the sample period. The effects from concurrent confounding macroeconomics events are thus minimized. Last, Taiwan did not have an option market for individual stocks until 2003. Therefore, short'selling is supposedly the only way to express investors private negative information. This offers a cleaner testing field.
Since the dynamics of short'sales constraints are at daily frequency, we have to take another trading restriction in Taiwan stock exchange into account. In our sample period, Taiwan has daily price limits of 7% for both sides based on the close price of the previous trading day. Proponents argue that investors are prone to overreact to new information. Price limits can provide a cooling off effect and reduce volatility. Opponents, however, argue that price limits merely delay price discovery and generate the volatility spillover to the subsequent day. Incorporating the price limits into our empirical tests is thus crucial to isolate the effects of short'sales constraints. Taiwan has one of the tightest price limits among the world stock markets. That also makes it one of the few markets that has price limits frequently reaching high enough to allow for empirical tests with sufficient statistical power. Given price limits are still imposed by U.S. futures market and by many other stock exchanges, the second contribution of this paper is to shed light on the impact of these limits on stock prices.
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