Fainanal Managament

7FINANCIAL MANAGEMENT

Financial Management

Abstract

Market regulators are concerned that short-selling may lead to excess stock price volatility. In 2008, the financial crisis across the globe worsened which led to many countries imposing restrictions on short selling of financial securities. The 2008 financial crisis led to rise in disorderly markets. There was therefore a need to protect the quality as well as the integrity of markets in order to ensure stability in the financial sector. This essay will investigate whether short selling restrictions in 2008 lead to curbing of excess stock price volatility. The analysis in the essay suggests that the short selling restrictions on financial securities had little impact on minimizing stock price volatility. Even with the restrictions in place, the stock prices still fell considerably. In addition, the short selling restriction led to decline in market liquidity and increase in trading costs. There is little evidence that the imposition of the short selling restrictions led to any long lasting positive effects on stock prices.

Introduction

Short selling can be termed as the practise of selling borrowed shares with the aim of repurchasing them in the future at considerably lower prices. As a result of the financial market volatility involving the collapse of Lehman Brothers, different nations decided to impose short selling restrictions on financial securities (Boehmer et al., 2009). The types of restrictions were different in different countries. For instance, in Germany, there were restrictions on naked short selling while in Australia and Korea, there were restrictions on both naked and covered short selling (Boehmer et al., 2009). Although short selling is considered a legitimate investment method, the financial condition in 2008 gave rise to disorderly markets (Asness, Krail and Liew, 2001). The primary purpose of short selling restrictions on financial securities was to eliminate excess stock price volatility. Short selling restrictions have huge impacts on the economy. Short selling restrictions have had huge impacts on the global economy and have had little impact on stock return. This paper is based on imposition of short selling restrictions on financial securities. It will discuss whether these restrictions were effective in accomplishing their purpose.

Financial Market

During market stress, there is often calls for restriction on short selling (Asness, Krail and Liew, 2001). The concern for many countries is that short selling of financial stock may lead to stock price volatility. In 2008, the financial crisis was at the peak which led to many countries imposing restrictions on short selling. Some nations imposed short selling restrictions on all stocks while others imposed the ban on only the financial stocks. Short selling regulation formed a priority on international agenda (Boehmer et al., 2009). There are three types of short selling restrictions; covered, naked and net position. Some countries that imposed short selling restrictions include Australia, United States, Germany, United Kingdom, Japan, Korea, Singapore and Italy among others. While the imposition of short selling restrictions was well coordinated around the same time, some countries did implement their restrictions overtime (Boehmer et al., 2009).

When different countries undertook impositions of short selling restriction, there was evident that the ban helped in stabilising prices in different markets (Hamson et al., 2008). However, the stabilization of the market was short lived since the global financial crisis and the market pace decline continued. For instance, in the United States, the average market decline before short selling bans was 10.7 per cent and after the ban, the market decline was about 18 per cent (Boehmer et al., 2009). In addition, the intra-day volatility increased dramatically as a result of short selling restrictions. Looking at the market returns illustrates that the restrictions of short selling did not reduce volatility. In Australia, it was reported that the restrictions on short selling on financial securities reduced market liquidity but led to the increase in intra-day volatility. According to Asquith et al. (2005), in the United Kingdom, as a result of the short selling ban, the market depth decreased. He concluded that liquidity decline is independent of market changes (Asness, Krail and Liew, 2001).

A research was conducted to determine the impacts of short selling restrictions on financial securities in the United States. It was found that the ban led to severe stock dilapidation in market quality. The study documented an increase in transaction costs which is due to short selling restrictions. Boehmer et al. (2009) conducted an analysis of the influence of short selling restrictions in thirty countries across the globe. The United States financial securities led to positive returns during the short selling ban which prevented stock prices from declining. Nevertheless, it was eminent that this positive impact was as a result of legislative efforts to support the financial institutions of the country during that period (Asquith et al., 2005). It was noted that for other countries where short selling restrictions were imposed and no legislative efforts were provided, the excess returns produced by the stocks were identical to stock returns generated during period of free short-sale ban. Therefore, the implementation of the short selling restrictions was neutral in its effects on stock prices. There was no strong evidence that short selling restrictions in any country changed the behaviour of stock prices (Diether et al., 2009).

As a result of the short selling ban, trade volumes declined considerably which affected the financial sectors across the globe with stockbrokers’ revenue declining (Battalio, Robert and Schultz, 2011). For instance, in Australia, there was a 16 per cent fall in trading volumes which represents a volume loss of about $640 million daily. The decline in trading volume have led to additional revenue losses such as lost exchange fee revenue and lost transaction income for stock administrators among others (Choi et al., 2010). In addition, the imposition of short selling ban on financial securities has led to negative impacts on transaction costs due to increased bid/ask spreads. For instance, 8bp increase in ask/bid spread provide an increase of $3.2 million daily in transaction costs in Australia (Boehmer et al., 2009). Also, with trading volume declining and volatility increasing due to short selling restrictions, the opportunity cost would also increase.

In the days after the imposition of the short selling restrictions, the financial securities’ prices experienced some stress (Choi et al., 2010). The large negative returns were experienced in the first day of short-sale ban. Few days afterwards, reports suggested buoyed returns (Asness, Krail and Liew, 2001). Despite the positive returns in the beginning of the imposition of the ban, the financial stock prices declined by more than 10 per cent over two weeks during which the short-sale restrictions were in effect. The precipitous market declines continued in many nations where imposition of short selling restrictions was in effect (Choi et al., 2010).

While many market regulators across the globe rallied on the imposition of short selling ban on financial securities, the effect proved to be short lived (Boehmer et al., 2009). Different markets experienced fast fall. What the short selling ban has done is to offer temporary circuit breaker. Stock prices continued to fall which led to economy deterioration. Stock volatility increased even after the imposition of the short selling ban. A theory was developed that explained that liquidity or transaction costs illustrate the equity risk premium. This means that higher transaction costs is linked to lower asset prices (Beber, Alessandro and Pagano, 2011). The theory illustrates that implementing a short selling restriction which increases transaction costs and decreases liquidity would put more pressure on already slumped equity markets. The theory argues that security prices may go down as a result of short sales constraints (Beber, Alessandro and Pagano, 2011). The imposition of short selling restrictions did not have any long lasting positive effects on stock price volatility, but they were able to reduce market liquidity as well as degraded market quality when the financial sector was suffering from economic decline.

Conclusion

In conclusion, due to 2008 financial crisis, many countries decided to impose short selling restrictions on financial stocks with an aim of curbing excess stock price volatility. The restrictions were imposed due to the fear that short selling will dramatically lower the prices of stocks. However, the effectiveness of the restrictions in stabilizing the markets has been put into question. Evidence from many countries suggests that the restrictions did little to curb the stock price liquidity. Also, short selling restrictions led to other negative effects on the economy such as the increase in trading costs and decline in market liquidity. In all the countries except the United States that imposed short selling restrictions on financial security, there was no effect on stock prices. Short selling restrictions only acted as circuit-breaker as it only brought about short term positive impacts on stock prices. Taken as a whole, the essay has challenged the notion that short selling restrictions during market challenges have the ability to curb excess stock price volatility.

References

Asness, C., Krail, R and Liew, J 2001, ‘Do hedge funds hedge?, Journal of Portfolio Management, vol. 28, no. 1, pp. 6-19.

Asquith, Paul, Parag A. Pathak, and Jay, R. Ritter. 2005,“Short Interest, Institutional Ownership, and Stock Returns,” Journal of Financial Economics, vol. 78, no. 2, pp. 243-76.

Battalio, R and P. Schultz. 2011, “Regulatory Uncertainty and Market Liquidity: The 2008 Short Sale Ban’s Impact on Equity Option Markets.” Journal of Finance, vol. 66, no. 6, pp. 2013-53.

Beber, A and Pagano, M 2011, “Short-Selling Bans Around the World: Evidence from the 2007-09 Crisis”, Journal of Finance, vol. 68, no. 1, pp. 343-381.

Boehmer, Ekkehart, Charles M. Jones, and Xiaoyan, Zhang 2009, “Shackling Short Sellers: The 2008 Shorting Ban.” Cornell University, Johnson School Research Paper Series, vol. 21, no. 34 pp. 9-11.

Choi, D., Mila Getmansky., Brian, H and Heather, T 2010, “Convertible Bond Arbitrageurs as Suppliers of Capital.” Review of Financial Studies, vol. 23, no. 6, pp. 2492-522.

Diether, Karl B., Kuan-Hui, L., and Ingrid, M 2009, “Short-Sale Strategies and Return Predictability,” Review of Financial Studies, vol. 22, no. 2, pp. 575-607.

Hamson, D., Wanzare, M., Smith, G. and Gardner, P 2008, ‘Has the short selling ban reduced liquidity in the Australian stock market?’, JASSA, no. 4, pp. 14-20.