Market Efficiency and Stability Under Short Sales Constraints: Evidence from a Natural Experiment with High-Frequency Resolution

Abstract

The six short-sales constraints (SSCs) regime changes from 2002 to 2009 in the Taiwan stock market provide “natural social” experiments to examine how different SSC intensities affect price adjustment efficiency and market stability. There are three main findings. Firstly, we derive the theoretical price with put–call parity from seven series index options. Using a “threshold error correction model” (TECM), we find a more efficient price adjustment to new equilibria for upward adjustments than for downward adjustments. The SSCs impede the price adjustment downward, especially during the financial crisis of 2008. Therefore, relaxing the short-sales constraints essentially improves price efficiency. Secondly, our findings also refute the claim that tighter SSCs can help stabilize the market since the tightening of the short-sales restriction leads to increases in both market volatility and downside risk even after controlling the investor fear gauge of the Taiwan volatility index (TVIX). These results hold even when market conditions and liquidity are controlled. Finally, the evidence from our counterfactual policy analysis suggests that tighter constraints help restore market confidence even though prices may fall more sharply without short-sales bans. As a result, policymakers may practically optimize to strike a balance between the benefits of restored emerging market order and the cost of elevated market volatility.

Keywords

• short-sales constraints
• price efficiency
• put–call parity
• threshold error correction
• counterfactual policy analysis