short-sales constraints and price discovery: evidence from the hong kong market

The University of Hong Kong

Short-Sales Constraints and Price Discovery:

Evidence from the Hong Kong Market

Eric C. CHANG and Yinghui YU

The University of Hong Kong

Presented by: Eric C. CHANG2004 NTU International Conference on Finance

2The University of Hong Kong

Introduction

• Objective

– Impact of short-sales constraints on pricing efficiency

• Price discovery

– Process of incorporating new information into asset prices

• Short-sales constraints (“SSC”)

– Asymmetric market friction

• Data from Hong Kong stock market, with unique short-sales restrictions


Introduction (II)

• Diverse short-sales practice across markets In the period of Jan. 1990 -- Dec. 2001,– Allowed and practiced

• U.S., U.K., Australia, Austria, Belgium, Canada, Denmark, France, Germany, Ireland, Italy, Japan, Mexico, the Netherlands, Portugal, South Africa, Switzerland (19)

– Prohibited• Colombia, Greece, Indonesia, Singapore, South Korea (12)

– Allowed but rarely practiced• Argentina, Brazil, Chile, Finland, India, New Zealand, the

Philippines, Poland, Spain, Turkey (11)

– Regulation and practice changed• Hong Kong, Norway, Sweden, Malaysia, and Thailand (5)

----Bris, Goetzmann, Zhu (2003)


Outline

• Theoretical background

• Existent empirical evidence

• Short Sales on Hong Kong Stock Market

• SSC and overvaluation

• SSC and distributions of stock returns

• Conclusions


Theoretical Background

• Miller (1977)’s intuition: With short-sales constraints, security prices tend to reflect the most optimistic opinion and thus to be upward-biased

• Short sales prohibited or costly

• Heterogeneous expectation among investors

• Figlewski (1981), Chen, Hong, and Stein (2002)

• Jarrow (1980): Not necessarily upward-biased

• Diamond and Verrecchia (1987): No overpricing on average in a rational-expectation framework


Existent Empirical Evidence

• Largely supports overvaluation

• Mostly indirect – Difficulty to quantify SSC

• Rebate rate • Frictions in lending market

• Tick rule • Short squeeze, etc.

• Bris, Goetzmann, Zhu (2003): Investigation across 47 countries

Assumptions in Measuring Short-Sales Constraints

Chen, Hong, and Stein

(2002)

The fewer shareholders, the more difficult to sell short

Danielsen and Sorescu (2001)

The availability of stock options can be regarded as being easier to sell short

Jones and Lamont

(2002)

Data are available between 1926 and 1933 showing that certain stocks are expensive to borrow


Short Sales on Hong Kong Stock Market

• A short-sales designation list since 1994– Only stocks on the list can be sold short

– Revised quarterly based on liquidity and market capitalization criteria

– On-the-list event & off-the-list event

• Therefore, we expect our empirical test – Direct (No proxies for short-sales constraints needed)

– Market-level and firm-level factors well controlled

– Off-the-list events as a mirror test


Effective Date Announcement

Date On-the-List Events

Off-the-List Events

Numbers of Stocks

on the List 3-Jan-94 N/A 17 0 17

25-Mar-96 7-Mar-96 96 0 113 1-May-97 29-Apr-97 129 0 241* 12-Jan-98 N/A 69 0 310 16-Mar-98 N/A 15 0 325 9-Nov-98 N/A 19 149 195 1-Mar-99 N/A 7 7 195 20-Sep-99 N/A 3 17 181 12-Nov-99 N/A 1 0 182 28-Feb-00 23-Feb-00 24 12 194 31-May-00 N/A 7 0 201 28-Aug-00 N/A 32 16 217 12-Feb-01 31-Jan-01 15 11 221 14-May-01 3-May-01 6 0 227 20-Aug-01 7-Aug-01 9 11 225 3-Dec-01 27-Nov-01 17 85 157 25-Feb-02 5-Feb-02 7 14 150 21-May-02 8-May-02 11 6 155 29-Jul-02 17-Jul-02 24 5 174 29-Nov-02 21-Nov-02 6 15 165 27-Jan-03 21-Jan-03 5 7 163

Cumulated: 519 355 448


SSC and Overvaluation

• Hypotheses – Stock prices will decrease (increase) when short-sales restrictions

are repealed (reinstated).

– The overvaluation effect of short-sales constraints is positively associated with the extent of dispersion of opinions, i.e., the more diverse the opinions, the more stock prices will decrease when short-sales restrictions are repealed.

• Abnormal Return Measures– Market model – Market-adjusted model

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Cumulated Abnormal Returns Around on-the-List Events

Variable Description Number of

Observations Mean Median Std. Dev. Min. Max.

ARm(0) 391 -0.00619 -0.00341 0.05030 -0.22355 0.22650 t-stat -2.43** CARm(0,5) 391 -0.02546 -0.00769 0.14478 -1.08932 0.53113 t-stat -3.48*** CARm(0,10) 391 -0.04524 -0.02154 0.17164 -0.91185 0.75878 t-stat -5.21*** CARm(0,15) 391 -0.05677 -0.03146 0.19959 -1.02121 0.76133 t-stat -5.62*** CARm(0,20) 391 -0.02154 -0.02458 0.18336 -0.60246 0.98045 t-stat -2.32** CARm(0,30) 391 -0.04648 -0.04519 0.23101 -1.01814 1.31484 t-stat -3.98***


-0. 12

-0. 1

-0. 08

-0. 06

-0. 04

-0. 02

0

0. 02

-30 -25 -20 -15 -10 -5 0 5 10 15 20 25 30 35 40 45 50 55 60

Event day relative to event date

Abn

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al R

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umul

ativ

e A

bnor

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Ret

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ARs of on-the-List Events CARs of on-the-List Events

`

Cumulated Abnormal Returns Around on-the-List Events

Result 1: Stock prices decrease when short-sales restrictions are repealed, i.e. short-sales constraints tend to cause overvaluation

event day


Tick Rule Effect

Result 1-2: Stock prices decrease more when short-sales constraints are repealed more thoroughly



Panel A: Tick Rule Effective (total 179 events) ARm(0,0) 149 -0.00070 -0.00187 0.03587 -0.15334 0.10836 t-stat -0.24 CARm(0,5) 149 -0.00081 -0.00097 0.07301 -0.24093 0.20461 t-stat -0.14 CARm(0,10) 149 -0.02287 -0.02662 0.12575 -0.49815 0.42628 t-stat -2.22** Panel B: Tick Rule Repealed (total 271 events) ARm(0,0) 242 -0.00957 -0.00483 0.05722 -0.22355 0.22650 t-stat -2.60*** CARm(0,5) 242 -0.04063 -0.01696 0.17332 -1.08932 0.53113 t-stat -3.65*** CARm(0,10) 242 -0.05901 -0.01630 0.19356 -0.91185 0.75878

t-stat -4.74***


Announcement Date or Effective Date?

• CARs Around Announcement Dates for on-the-List Events

Result 1-3: It suggests that price changes are triggered by short-sales restriction changes, not by the news of changes

Panel A: On-the-List Events (total 309 events)



ARm(0,0) 267 0.00241 -0.00047 0.04027 -0.07887 0.32424 t-stat 0.98 CARm(0,1) 267 0.00156 -0.00257 0.05264 -0.17172 0.27962 t-stat 0.48 CARm(0,2) 267 -0.00614 -0.01279 0.06913 -0.24039 0.33772 t-stat -1.45


What to Expect for off-the-List Events?

• Cumulated Abnormal Returns Around off-the-List Events



ARm(0) 306 0.00686 0.00510 0.04922 -0.20128 0.30974

t-stat 2.44** CARm(-15,-1) 306 0.07995 0.03922 0.21874 -0.38878 1.27211 t-stat 6.39*** CARm(-10,-1) 306 0.05857 0.02370 0.16880 -0.39581 1.03514 t-stat 6.07*** CARm(-5,-1) 306 0.02998 0.00850 0.12389 -0.36733 0.92552 t-stat 4.23*** CARm(-10,10) 306 0.07666 0.03762 0.26646 -0.58785 1.34196 t-stat 5.03*** CARm(-10,20) 306 0.06261 0.03871 0.28453 -0.69502 1.32485 t-stat 3.85***


-0. 02

0

0. 02

0. 04

0. 06

0. 08

0. 1

0. 12

0. 14

-30 -25 -20 -15 -10 -5 0 5 10 15 20 25 30 35 40 45 50 55 60

Event day relative to event date

Abn

orm

al R

etur

n / C

umul

ativ

e A

bnor

mal

Ret

urn

ARs of off-the-List Events CARs of off-the-List Events

`

Cumulated Abnormal Returns Around off-the-List Events

Mirror Result 1: Stock prices increase when short-sales restrictions are reinstated ---- Still, short-sales constraints are associated with overvaluation

event day


Is It Announcement Effect?

• CARs Around Announcement Dates for off-the-List Events

• Mixture of Two Effects Suggested– Announcement of off-the-list events is immediately bad news

– Investors expect off-the-list events prevent future negative information from being impounded into the stock prices, and trade in advance.

Panel B: Off-the-List Events (total 149 events)



ARm(0,0) 148 -0.00801 -0.00809 0.03254 -0.12409 0.14824 t-stat -3.00*** CARm(0,1) 148 -0.01914 -0.01729 0.04643 -0.15470 0.15191 t-stat -5.02*** CARm(0,2) 148 -0.01715 -0.01754 0.06322 -0.20664 0.16852 t-stat -3.30***


Model Specification No. 1 2 3 4 5 6 7 8 9 10 Dependent Variable CARm CARm CARm CARm CARm CARa CARm CARm CARm CARm Intercept 0.0117 0.0044 -0.0107 -0.0435 0.0139 -0.0042 -0.0452 0.02623 0.02694 0.0067 (t= 0.81) (t=0.31) (t=-1.04) (t=-5.02)*** (t=0.80) (t=-0.25) (t=-5.17)*** (t=1.48) (t=1.50) (t=0.39) SIGMAraw -1.5167 -1.20709 (t= -4.80)*** (t=-3.16)*** SIGMAab -1.4295 -1.05113 (t=-4.29)*** (t=-2.77)*** TURNOVER -5.2426 -4.5575 (t= -5.65)*** (t=-4.25)*** ALPHA 4.09826 (t=2.09)** BETA -0.0721 -0.0529 -0.03208 -0.04372 -0.0269 (t=-3.86)*** (t=-2.89)*** (t=-1.43) (t=-2.06)** (t=-1.27) SSVOL 5.1777 (t=0.55) No. of Observations 390 390 390 390 390 390 390 390 390 390 Adjusted R-Square 0.0536 0.0428 0.0736 0.0086 0.0344 0.0185 -0.0018 0.0562 0.0508 0.0750

SSC, Overvaluation, and Dispersion of Opinions

• Cross-sectional regressions of CARs around on-the-list events over dispersion of opinions

Result 2: The more diverse the investors’ opinions, the more stock prices will decrease when short-sales restrictions are repealed


SSC, Overvaluation, and Dispersion of Opinions (II)

• Tick Rule Effect

• Result 2-2: Dispersion of investors’ opinions is associated with more decrease in stock prices when short-sales constraints are repealed more thoroughly

Panel A: Tick Rule Effective (total 179 events) Model Specification No. 1 2 3 4

Dependent Variable CARm CARm CARm CARm

Intercept 0.01132 0.01160 -0.01018 -0.01467 (t=0.67) (t=0.71) (t=-0.80) (t=-0.74) SIGMAraw -0.72141 (t=-2.52)** SIGMAab -0.77971 (t=-2.69)*** TURNOVER -1.70222 (t=-1.67)* BETA -0.00942 (t=-0.48) No. of Observations 148 148 148 148 Adjusted R-Square 0.03510 0.04070 0.01210 -0.00530

Panel B: Tick Rule Repealed (total 271 events) 1 2 3 4

CARm CARm CARm CARm

0.09414 0.09334 -0.00588 0.05585 (t=4.03)*** (t=3.73)*** (t=-0.41) (t=2.15)**

-4.91680 (t=-7.43)***

-5.34018 (t=-6.81)*** -8.83462 (t=-6.31)*** -0.14563 (t=-4.94)***

242 242 242 242 0.18340 0.15840 0.13860 0.08870


Model Specification No. 1 2 3 4 5 6 7 8 9 10 Dependent Variable CARm CARm CARm CARm CARm CARa CARm CARm CARm CARm

Intercept 0.0242 0.0298 0.0848 0.0425 0.0597 0.0343 0.0638 0.0256 0.0294 0.0704 (t=0.94) (t=1.19) (t=6.97)*** (t=3.77)*** (t=2.98)*** (t=1.87)* (t=6.06)*** (t=0.89) (t=1.02) (t=3.54)*** SIGMAraw 0.8453 0.8560 (t=1.67) (t=1.66)* SIGMAab 0.7518 0.7500 (t=1.46) (t=1.45) TURNOVER -4.8781 -5.1554 (t=-3.37)*** (t=-3.49)*** ALPHA -11.17034 (t=-4.32)*** BETA 0.0060 0.0130 -0.0034 0.0009 0.0278 (t=0.20) (t=0.47) (t=-0.11) (t=0.03) (t=0.91) SSVOL -0.8999 (t=-0.92) No. of Observations 306 306 306 306 306 306 306 306 306 306 Adjusted R-Square 0.0058 0.0037 0.0329 0.0548 -0.0032 -0.0026 -0.0005 0.0026 0.0004 0.0324

SSC, Overvaluation, and Dispersion of Opinions (III)

• Cross-Sectional Regressions of CARs Around off-the-List Events over Dispersion of Opinions

Mirror Result 2: Basically, it still holds that the more diverse opinions, the larger overvaluation effect of short-sales constraints


SSC and Distributions of Stock Returns

• Skewness, volatility of returns, and market crashes (frequency of extreme negative returns)

Short Selling

Prohibited Short Selling

Allowed Difference

Mean Median Mean Median t-Statistics

p-Value of Sign Test

p-Value of Signed Rank Test

No. of Obs.

Panel A: On-the-List Events 353 Mean Raw Returns 0.0012 0.0010 -0.0006 -0.0003 7.46*** 0.0000 0.0000 Raw Returns 0.0369 0.0299 0.0415 0.0398 -2.89*** (0.0884) (0.0006)

Standard Deviation Abnormal Returns 0.0340 0.0286 0.0375 0.0361 -2.36** (0.0702) (0.0004)

Raw Returns 0.8698 0.7800 0.7083 0.6316 1.34 0.0040 0.0086

Skewness

Abnormal Returns 0.9392 0.8212 0.7812 0.6600 1.29 0.0105 0.0050

Return<Mean-2*Stdev 0.0201 0.0201 0.0200 0.0208 0.0200 -1.09 (0.0105)

Panel B: Off-the-List Events 202 Mean Raw Returns 0.0006 0.0002 -0.0006 -0.0010 2.63*** 0.0059 0.0075 Raw Returns 0.0436 0.0371 0.0467 0.0460 -0.76 (0.0000) (0.0000)

Standard Deviation Abnormal Returns 0.0424 0.0351 0.0449 0.0435 -0.60 (0.0000) (0.0000)

Raw Returns 1.0819 0.6566 0.2290 0.4115 4.99*** 0.0009 0.0000

Skewness

Abnormal Returns 1.1171 0.6964 0.2172 0.4212 5.15*** 0.0000 0.0000

Return<Mean-2*Stdev 0.0206 0.0200 0.0217 0.0200 -1.49 (0.7527)


SSC and Distributions of Stock Returns (II)

Result 3: When short sales are allowed, stock returns exhibit higher volatility and less positive skewness, while no significant difference is observed in the frequency of extreme negative daily returns


Conclusions and Future Research

• Conclusions

– Short-sales constraints tend to cause stock overvaluation

– The wider dispersion of investor opinions, the more dramatic the overvaluation

– When short sales are allowed, individual stock returns seem to exhibit higher volatility and less positive skewness

• Future Research

– Short-sales-constrained stocks respond more slowly to bad news than to good news?

– Market makers set wider bid-ask spreads to protect themselves?

– Tailored theoretical model

short-sales constraints and price discovery: evidence from the hong kong market

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