Market-Wide Short-Selling Restrictions *

Abstract

Abstract In this paper, we examine the effect of market-wide short-sale restrictions on skewness, volatility, probability of market crashes, liquidity, and expected market returns or the cost of capital. We report new data on the history of short-selling and put option trading regulations and practices from the 111 countries that have a stock exchange, and create a short-selling feasibility indicator for the analysis of stock market indices around the world. We find that short-sale restrictions do not affect either the level of skewness of returns or the probability of a market crash. When short-selling is possible, aggregate stock returns are less volatile and there is greater liquidity. Expected returns are lower when short-selling is possible, and when countries start allowing short-selling, aggregate stock price increases. This result differs from the effect of short-selling constraints of individual stocks on stock returns reported in existing studies. At the market level, the lower expected return investors require due to lower volatility and increase liquidity dominates the Miller (1977)' over pricing effect, which appears to dominate at the firm level. Collectively, our empirical evidence suggests that allowing short sales enhances market quality. JEL classification code: G15, G12 Keywords: Short-sale constraints; Stock returns; Cost of capital; International finance * This research would not have been possible without the information we received from representatives of the 111 stock markets and foreign nationals in the finance industry whom we contacted. We are deeply indebted to them. We would also like to thank Alex Butler, Carole Market-Wide Short-Selling Restrictions Abstract In this paper, we examine the effect of market-wide short-sale restrictions on skewness, volatility, probability of market crashes, liquidity, and expected market returns or the cost of capital. We report new data on the history of short-selling and put option trading regulations and practices from the 111 countries that have a stock exchange, and create a short-selling feasibility indicator for the analysis of stock market indices around the world. We find that short-sale restrictions do not affect either the level of skewness of returns or the probability of a market crash. When short-selling is possible, aggregate stock returns are less volatile and there is greater liquidity. Expected returns are lower when short-selling is possible, and when countries start allowing short-selling, aggregate stock price increases. This result differs from the effect of short-selling constraints of individual stocks on stock returns reported in existing studies. At the market level, the lower expected return investors require due to lower volatility and increase liquidity dominates the Miller (1977)' over pricing effect, which appears to dominate at the firm level. Collectively, our empirical evidence suggests that allowing short sales enhances market quality.