Short Sale Constraints and Single Stock Futures Introductions

• DOI: http://doi.org/10.1111/fire.12147
• Date: 01 February 2018
• Published date: 01 February 2018

The Financial Review 53 (2018) 5–50

Short Sale Constraints and Single Stock

Futures Introductions

Louis Gagnon

Queen’s University

Abstract

This paper exploits the unique experimental setting created by nearly 1,300 new single

stock futures listings on the OneChicago exchange between 2003 and 2009. I investigate

the impact of derivatives introductions on the tightness of short sale constraints facing their

underlying assets. After controlling explicitly for supply and demand conditions in the stock

lending market, this experiment revealsa precipitous decline in active utilization rates and loan

fees in the lending market, after the futures introductions. The paper provides strong evidence

that supports the view that derivativesrepresent a viable alternate synthetic short selling venue

relaxing short sale constraints facing their underlying assets.

Keywords: derivatives, single stock futures,short sale constraints, overpricing, stock lending

market, market efficiency

JEL Classifications: F30, G01, G18, G20

Corresponding author: Professor of Finance and Distinguished Faculty Fellow, Smith School of Busi-

ness, Queen’s University, Kingston, Ontario, K7L 3N6; Phone: (613) 533-6707; Fax: (613) 533-2755;

E-mail: louis.gagnon@queensu.ca.

I am grateful for financial support from the Social Sciences and Humanities Research Council of Canada.

I thank two anonymous referees, Richard S. Warr(the editor), Bo Young Chang, Christian Dorion, David

Downey (OneChicago), Sandra Fenandes (Markit), Pascal Franc¸ois, Zsuzsa Huszar, Pankaj Jain, Andrew

Karolyi, Vassil Mihov, Suneet Ranga (Markit), Andriy Shkilko, and Jonathan Witmer for their valuable

comments and suggestions, as well as participants at the inaugural conference of the Institut de la Finance

Structur´

ee et des Instruments D´

erives de Montr´

eal (IFSID) in 2012, the 2013 FMA Europe conference

in Luxembourg, and the 2013 annual meetings of the Financial Management Association in Chicago. I

also thank Frederic Davis, Xiaoya Ding, Sharlene He, Michael Portner-Gartke, Bryan Samis, and Caroline

Trevithick for their invaluableassistance. All remaining errors are mine.

C2018 The Eastern Finance Association 5

6L. Gagnon/The Financial Review 53 (2018) 5–50

1. Introduction

Although the notion is intuitively appealing that derivatives relax short sale

constraints facing their underlying assets, there is no consensus in the literature

regarding this important question. This lack of consensus is likely due to two main

reasons. First, from a theoretical perspective, the impact of short sale constraints on

asset prices is ambiguous, so it is difficult to infer whether derivatives introductions

relax short sale constraints simply by observing their impact on the price of their

underlying assets. Miller (1977) argues that short sale constraints prevent bearish

investorsfrom impounding their pessimistic beliefs into prices, so optimistic investors

end up pushing prices above their equilibrium level. From this point of view, to the

extent that derivatives provide investors with a viable and cost-effective alternative

to implementing short sales, one would expect derivatives introductions to exert

downward pressure on the price of their underlying assets and, ultimately, to reduce

the extent of overpricing.

In contrast, Diamond and Verrecchia (1987) postulate a rational expectations

model in which investors adjust their expectations to incorporate any effects of short

sale constraints on prices. Their model shows that although short sale constraints

reduce the speed at which prices adjust to news, especially bad news, they do not give

rise to overpricing. Hong and Stein (2003) argue that short sale constraints lead not

to overpricing, but to price instability or to excess volatility. From this perspective,

derivatives introductions should have no impact on the price of their underlying

assets, even if they do relax short sale constraints.1

One might be tempted to interpret the post-listing decline in the price of stocks

underlying newly listed options reported by Detemple and Jorion (1990), Figlewski

and Webb (1993), and Sorescu (2000), as evidence that derivatives do relax short

sale constraints. However, from a theoretical perspective, the price impact is neither

a necessary nor a sufficient condition to reach such a conclusion. In other words,

derivativesmay alleviate short sale constraints even if they do not have a price impact

or, conversely, they may induce a price impact even if they do not relax short sale

constraints.

Second, from an empirical perspective, short sale constraints are inherently dif-

ficult to measure. Figlewski and Webb (1993) rely on short interest as a proxy for

short sale constraints and document an increase in short interest around option intro-

ductions between 1973 and 1983. Danielsen and Sorescu (2001) examine a broader

sample of new option listings (2,051) over a longer sample period (1973–1995) and

document a likewise positive association between new option listings and the level

of short interest in the underlying stocks. Both papers interpret this finding as being

consistent with the notion that options introductions relax short sales constraints.

1Consistent with the theoretical predictions of Hong and Stein (2003), Conrad (1989) and Damadoran and

Lin (1991) document an increase in stock return volatility after the options introductions on the Chicago

Board Options Exchange (CBOE).

L. Gagnon/The Financial Review 53 (2018) 5–50 7

However, short interest has serious limitations as a proxy for short sale constraints.

Dechow, Hutton, Meulbroek and Sloan (2001) report that more than 98% of stocks

listed on the NYSE/Amex over the period 1976–1993 had short interest of less than

5%. Chen, Hong and Stein (2002, p. 173) argue, “there need be no clear-cut relations

between short interest and subsequent returns” and propose a mutual funds’ breadth

of ownership as a more viable proxy for short sale constraints. They hypothesize

that the lower the breadth of ownership in a stock, the larger the number of investors

who are “sitting on the sidelines,” unable to impound their pessimistic information

in the stock’s price. Using mutual fund holdings data, they find that stocks falling in

the lowest breadth of ownership decile outperform top decile stocks by 4.95% in

the 12 months following the formation of the sample deciles, adjusting for size,

book-to-market, and momentum. Nagel (2005) modifies this proxy by considering

the percentage of shares owned by institutions instead of the number of institutions

owning the stock. D’Avolio(2002) finds that this refined proxy explains an average of

55% of the cross-sectional variation in the lender’s supply of lendable shares scaled

by shares outstanding.2

Mayhew and Mihov (2005) attempt to control for the shortcomings of short

interest, as a proxy for short sale constraints, by using signed trading volume in the

options as a gauge of investors’ bearishness. They examine a sample of 1,039 newly

CBOE-listed options between June 1980 and January 1997 and find no evidence that

investorstake disproportionately bearish positions in newly listed options. Lundstrum

and Walker (2006) report similar findings based on a sample of long-term equity

anticipation securities introduced between 1990 and 2003. Despite their attempt to

circumvent the shortcomings of short interest, as a measure of short sale constraints,

these experiments only account for one of the two dimensions of short sale constraints,

namely, the demand side.

However, Asquith, Pathak and Ritter (2005) stress the need to account for both

the supply and demand side of the lending market in any empirical assessment of the

price impact of short sale constraints. Using data on both short interest (a proxy for

demand) and institutional ownership (a proxy for supply), they find that short sale

2Several studies exploit changes in market structure or in regulation to document the detrimental impact

of short sale constraints on prices, including Ho (1996), Rhee (2003), Chang, Cheng and Yu(2007), Chan,

Kot and Yang(2010), Diether, Lee and Werner (2009), and Boehmer, Jones and Zhang (2008). The short

sale ban of 2008 also provides an ideal experimental setting to investigatethis question. Studies that focus

on this episode document a significant deterioration in market quality among the stocks subjected to the

ban (Gurliacci, Jeria and Sofianos, 2008; Helmes, Henker and Henker, 2010; Beber and Pagano, 2013;

Boehmer, Jones and Zhang, 2013); positive and statistically significant excess returns among short sale

banned stocks (Autore, Billingsley and Kovacs,2011); a destabilizing influence on prices at the daily and

intraday frequency (Bailey and Zheng, 2013); an increase in options trading costs and trading volumes

(Battalio and Schultz, 2011; Grundy, Lim and Verwijmeren, 2012); an increase in informed short selling

(Kolasinski, Reed and Thornock, 2013); a decline in stock borrowing activity in the home marketof U.S.

cross-listed stocks (Jain, Jain, McInish and McKenzie, 2013); and a significant but short-livedincrease in

price differentials among U.S. cross-listed stocks subjected to the short sale ban at home and in the United

States simultaneously (Gagnon and Witmer, 2014).