Asset Prices under Short-Sales Constraints

Abstract

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 to share risk and to speculate on private information in the presence of 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. However, limiting short sales driven by private information increases the uncertainty about the asset as perceived by less informed investors, which reduces their 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 short-sale constraints can give rise to discrete price drops accompanied by a sharp rise in volatility when prices fail to be informative and the uncertainty perceived by uninformed investors surges.