Asset Prices Under Short-Sale Constraints

In this paper, we study how short-sale constraints affect asset price and market efficiency. We consider a fully rational expectations equilibrium model, in which investors trade for two reasons, to share risk and to speculate on private information, but they face short-sale constraints. Short-sale constraints limit both types of trades, and thus reduce the allocational and informational efficiency of the market. Limiting short sales driven by risk-sharing simply shifts the demand for the asset upwards and consequently its price. We show that in the presence of information asymmetry, limiting short sales driven by private information increases the uncertainty about the asset as perceived by uninformed investors, which reduces the demand for the asset. When this information effect dominates, short-sale constraints actually cause asset prices to decrease and price volatility to increase. Moreover, we show that shortsale constraints can give rise to discrete price drops accompanied by increases in volatility when the uncertainty perceived by uninformed investors surges in certain states. ∗Bai ([email protected]) and Chang ([email protected]) are from the School of Business, University of Hong Kong, and Wang ([email protected]) is from the Sloan School of Management, MIT, CCFR and NBER.