Short-Sales Constraints and Price Discovery: Evidence from the Hong Kong Market

1. 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. CHANG 2004 NTU International Conference on Finance

2. 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

3. Introduction (II) • Diverse short-sales practice across markets In the period ofJan. 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)

4. Outline • Theoretical background • Existent empirical evidence • Short Sales on Hong Kong Stock Market • SSC and overvaluation • SSC and distributions of stock returns • Conclusions

5. 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

6. 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

7. 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

9. 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

10. Cumulated Abnormal Returns Around on-the-List Events

11. Cumulated Abnormal Returns Around on-the-List Events event day Result 1: Stock prices decrease when short-sales restrictions are repealed, i.e. short-sales constraints tend to cause overvaluation

12. Tick Rule Effect • Result 1-2: Stock prices decrease more when short-sales constraints are repealed more thoroughly

13. 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

14. What to Expect for off-the-List Events? • Cumulated Abnormal Returns Around off-the-List Events

15. 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

16. 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 beingimpounded into the stock prices, and trade in advance.

17. 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

18. 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

19. 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

20. SSC and Distributions of Stock Returns • Skewness, volatility of returns, and market crashes (frequency of extreme negative returns)

21. 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

22. 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