Dynamic short-sale constraints, price limits, and price dynamics

Purpose – The purpose of this paper is to take advantage of a natural experiment in Taiwan to test the effect of short-sales constraints on price dynamics. Design/methodology/approach – Since September 1998, short-selling is banned at a price below the close price of the previous trading day. The new rule creates unique daily dynamics of short-sales constraints. The paper employs a difference-in-difference method to evaluate whether the short-sales constraint rule plays an important role in the price dynamics. Findings – The results show that stock prices react to information in a way similar to if short-selling was not banned. This is in line with the implication of a rational expectation framework like Diamond and Verrecchia. Research limitations/implications – The paper has implications on the short selling bans in the 2008/2009 credit crisis and the European debt crisis because the bans are public information as those in this setting. The rational agents in the market could incorporate the bans into price beliefs which could lead to the ineffectiveness of the policy. The short-sales constraints may be widely imposed in the crisis but they are not the effective tools to alleviate downward price pressures. Practical implications – The results suggest that the effort of the government to boost stock price by imposing short sales constraints will not be effective if rational investors take the constraints into account while forming their beliefs. Originality/value – Unlike existing short-sales constraint proxies like short interest or lending fees, the dynamic constraints do not suffer from endogeneity. Moreover, the constraints are public information and thus ideal for testing the rational expectation models, in which investors have to be aware of the level of the constraints.