The Pricing of Stock Ambiguity and Short-Sale Constraints

This paper studies the pricing of ambiguity or Knightian uncertainty in China stock market with binding short-sale constraints. We measure the stock ambiguity by the dispersion in the probability distribution of the daily stock returns estimated from the trading data, based on the method proposed by Izhakian (2017). We find that stocks with a high level of ambiguity have a significantly lower expected return of -13% than those with low ambiguity, equally-weighted or value-weighted, with or without adjustment for the well-known risk factors. Furthermore, the ambiguity premium remains significantly negative, and the magnitude does not decrease, albeit the dispersion in cross-section ambiguity shrinks after the margin trading was allowed for a limited group of stocks on March 31, 2010. The negative ambiguity premium implies a large price distortion due to short-sale constraints. The explicit and implicit costs of short selling are high in the China stock market and remain high after margin trading was allowed, as it is hard to borrow securities. Our results imply the importance of market design to encourage long-term investors and effectively reduce short-selling costs