The Price Impact of Borrowing and Short-Sale Constraints

This study explores how trading constraints such as borrowing and short-sale constraints affect asset prices in the presence of asymmetric information. In a symmetric information environment, borrowing and short-sale constraints exacerbate downward and upward price movements, respectively. However, in the presence of information asymmetry, the price impact of each constraint is different. In an asymmetric information environment, prices play an important role in shaping uninformed investor expectation. Uninformed investors are uncertain whether trading constraints restrict informed investors from transmitting information to prices, and thus they demand an information-disadvantaged premium in holding stocks. This creates a large price decline. Hence, information asymmetry combined with short-sale constraints dampens the upward price movement while information asymmetry combined with borrowing constraints intensifies the downward price movement. The model also generates the following empirical predictions: 1) prices at extreme tails are less informative of the asset fundamental; 2) bad news creates greater return volatility than good news; 3) crashes are more likely than bubbles; and 4) the skewness in returns is more pronounced in stocks with severe information asymmetry and with a greater percentage of constrained informed investors. Journal of Economic Literature Classification Codes: D82, D84, G14.