Asset Pricing Implications of Short-Sale Constraints in Imperfectly Competitive Markets

We study the impact of short-sale constraints on market prices and liquidity in imperfectly competitive markets in which market makers have market power. In contrast to the existing literature, we show that because competition is imperfect, short-sale constraints decrease bid prices, increase ask prices, and drive up bid-ask spread volatility, with or without information asymmetry. If market makers are risk neutral, then short-sale constraints do not affect ask prices or ask depths. In addition, the impact of short-sale constraints can increase with market transparency. Our main results are unaffected by endogenous information acquisition or reduced information revelation because of short-sale constraints.

This paper was accepted by Gustavo Manso, finance.