The World Price of Short Selling

This paper provides empirical evidence relevant to the ongoing debate about how short-sale constraints affect aggregate market returns and whether short sales should be allowed. The study focuses on two main questions. What is the effect of short-sale constraints on skewness, coskewness, volatility, the intensity and severity of market crashes, and liquidity? What is the effect on the cost of capital? We collect and report new data on the history of short-sale and put option trading regulations and practices from the 111 countries that have stock markets. We employ panel regressions and event study in our analysis. We find that there is no difference in the level of skewness and coskewness of returns, probability of a crash occurring, or the frequency of crashes, when short-selling is possible and when it is not. When short-selling is possible, volatility of aggregate stock returns is lower. When short-selling is possible, liquidity is higher consistent with predictions by Diamond and Verrecchia (1987). Lastly, we find that when countries change from a regime where short-selling is not possible to where it is possible, the stock price increases implying that the cost of capital is lower. Collectively, the empirical evidence suggests that short-sale constraints reduce market quality.