Short Sale Constraints and Single Stock Futures Introductions

Date01 February 2018
Published date01 February 2018
The Financial Review 53 (2018) 5–50
Short Sale Constraints and Single Stock
Futures Introductions
Louis Gagnon
Queen’s University
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;
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
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.
C2018 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
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).

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