Short Selling, Regulatory Flip/Flops and Uncertainty : Implications for Asset Pricing and Asset Allocation

After seventy years with no changes to short sale regulation, the United States Securities and Exchange Commission intervened three times with regulatory action from July 2007 through October 2008. The Commission first loosened restrictions on short sales by repealing the “Uptick Rule” in July 2007. Then, amidst declining markets of July of 2008 and heightened uncertainty, the SEC issued a temporary order to restrict naked short sales in a small set of financial stocks, letting the order expire shortly thereafter. Just a month later, in September 2008, the SEC again intervened with an order restricting naked shorting in all stocks, and temporarily banning short sales in a large set of financial stocks. While classical models make predictions about how stock prices react to short sale constraints, they offer little insight into how regulatory changes and regulatory uncertainty about short sales affect the wider market. In this paper we investigate the spillover effect of the SEC regulatory flip flops on the U.S. market as a whole by examining the impact of changes from the perspectives of asset pricing and asset allocation. We find that all three regulatory changes significantly impact risk premia, with impacts differing across priced factors. We discover, however, that the welfare cost on out of sample returns for a broad equity long only investor is less clear cut, ranging from no impact for the first two regulatory actions to a significant daily loss from the September 2008 ban depending on the portfolio strategy employed