1. 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. CHANG 2004 NTU International Conference on Finance

2. The University of Hong Kong 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. The University of Hong Kong 3 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)

4. The University of Hong Kong 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. The University of Hong Kong 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. The University of Hong Kong 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 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

7. The University of Hong Kong 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

8. The University of Hong Kong 8

9. 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. The University of Hong Kong 10 Cumulated Abnormal Returns Around on-the-List Events

11. The University of Hong Kong 11 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

12. The University of Hong Kong 12 Tick Rule Effect Result 1-2: Stock prices decrease more when short-sales constraints are repealed more thoroughly

13. The University of Hong Kong 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. The University of Hong Kong 14 What to Expect for off-the-List Events? Cumulated Abnormal Returns Around off-the-List Events

15. The University of Hong Kong 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. The University of Hong Kong 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 being impounded into the stock prices, and trade in advance.

17. The University of Hong Kong 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. The University of Hong Kong 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. The University of Hong Kong 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. The University of Hong Kong 20 SSC and Distributions of Stock Returns Skewness, volatility of returns, and market crashes (frequency of extreme negative returns)

21. The University of Hong Kong 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. The University of Hong Kong 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