The Causal Impact of Short-sale Constraints on the Idiosyncratic Volatility Puzzle

This paper investigates the causal impact of short-sale constraints on the idiosyncratic volatility (IVOL) puzzle. Our identification strategies rely on two opposing exogenous shocks to short-sale constraints: (1) Regulation SHO which relaxes constraints for pilot stocks; (2) the Job and Growth Tax Relief Reconciliation Act (JGTRRA) of 2003 which tightens constraints in dividend record months. Using Regulation SHO, we find a substantial decrease in the pricing effect of IVOL for pilot stocks relative to non-pilot stocks. Additionally, we observe a considerable increase in the pricing effect of IVOL following dividend record months after the enactment of JGTRRA. Collectively, this paper suggests that short-sale constraints are important for the IVOL puzzle