The impact of short selling on the volatility and liquidity of stock markets: evidence from Hong Kong market

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1 The impac of shor selling on he volailiy and liquidiy of sock markes: evidence from Hong Kong marke Miaoxin Chen 1 Zhenlong Zheng 2 1 Deparmen of Finance, Xiamen Universiy, China. cuecmx@163.com 2 Deparmen of Finance, Xiamen Universiy, China. zlzheng@xmu.edu.cn Absrac The debae among various marke paricipans on he shor-selling of securiies coninues oday. Opponens of shorselling argue ha i disrups orderly markes by causing panic selling, high volailiy, and marke crashes. So his paper invesigaes wha he impac of shor selling on he volailiy and liquidiy of he Hong Kong sock marke is, and he resuls indicae ha shor selling volumes do no Granger-cause marke volailiy, bu volailiy Granger-cause shor selling volumes. Moreover Granger causaliy ess show ha here is a bi-direcional causaliy relaionship beween shor selling volumes and marke liquidiy. Keywords: Shor Sales; Volailiy; Liquidiy 1. Inroducion A shor sale is a sale of a securiy ha he seller does no own or any sale ha is consummaed by he delivery of a securiy borrowed by he seller. Alhough shor selling is currenly legal in more and more counries, selling shor can be expensive due o all kinds of shor sale consrains, including various coss and risks of shoring, as well as insiuional resricions. Opponens of shor-selling argue ha i disrups orderly markes by causing panic selling, high volailiy, and marke crashes. While supporers of shor-selling argue ha i increases informaion efficiency and liquidiy of sock markes, and improves he risk sharing mechanism of economic sysem. The debae among various marke paricipans on he shor-selling of securiies coninues oday. One of he mos debaable issues concerns wheher or no shor selling exers an unfavorable effec on he volailiy and liquidiy of sock markes. In an aemp o answer his issue, his paper invesigaes he relaionship beween shor selling and he sock marke volailiy and liquidiy using Granger causaliy ess in he conex of he Hong Kong sock marke. The main conribuions of our sudy are as follows. Firs, mos of he previous sudies have focused only on U.S. sock markes which employ specialiss or marke makers who have an affirmaive obligaion o mainain a fair and orderly marke. Many oher sock markes such as he Hong Kong sock marke which is he research objec of our sudy, however, are operaed by elecronic order maching aucion sysems wihou marke makers. Such difference in marke microsrucure could give us an appropriae environmen o invesigae he differen impac of marke microsrucure on shor selling. Second, mos of he available empirical sudies have examined he impac of shor selling a he individual sock level which may differ significanly from he marke-wide level.

2 From he viewpoin of sock marke regulaion, governmen regulaors could be ineresed in he effec of shor selling a an aggregaed sock marke level raher han a an individual sock level. Therefore, differing from mos of he previous research, our sudy aemps o invesigae how shor selling impacs he aggregae marke volailiy and liquidiy. Perhaps closes o our analysis is he work by Liao and Yang (2005). They also invesigae he impac of shor selling on he volailiy and liquidiy of he Hong Kong sock marke a an aggregaed marke level bu use monhly daa, our daa frequency, sample period, research mehods, measuremen of marke volailiy and liquidiy are all differen from heirs. 2. Lieraure Review Academic lieraure on shor selling has had a renaissance from he 1970s. As o he impac of shor selling on marke volailiy, mos of he previous empirical sudies have shown evidences ha shor selling do no increase he volailiy of sock marke. For example, by examining he fill rae of shor-sale orders, Angel (1997) concludes ha he Up-ick Rule impedes shor-selling aciviy, and i is no shor-sale orders bu ordinary orders make he marke more volaile. The Chase Manhaan Bank and he ASTEC Consuling Group (2000) shows ha he shor selling ineress on NYSE and he sock index of NYSE have similar rend of movemen from 1990 o A series of papers by Liao (see Liao and Zhang (2005), Liao and Yang (2005a, 2005b), Wu and Liao (2007), ec.) invesigae he relaionship beween marke volailiy and shor sales in Hongkong and Taiwan sock markes based on he coinegraion and Granger causaliy ess, and he resuls sugges ha shor sales play an imporan role in buffering sock volailiy insead of aggravaing i. Bris, Goezmann and Zhu (2004) also finds ha he non-shorable index is more volaile han he shorable index using he daa from 47 counries. Moreover, Charoenrook and Daouk (2005) invesigaes he hisory and curren pracice of shor-selling in 111 counries, and hey find ha when shorselling is possible, aggregae sock reurns are less volaile, and he feasibiliy of shor-selling has no relaion o he probabiliy of a marke crash. As o he impac of shor selling on marke liquidiy, he empirical evidences are ambiguous. Woolridge and Dickinson (1994) finds a posiive correlaion beween shor ineres changes and sock reurns in U.S marke. From heir resuls, hey conclude ha shor sellers provide liquidiy o he marke by shoring ino bullish markes and reducing shor posiions in bearish markes. Charoenrook and Daouk (2005) uses urnover as a proxy for liquidiy, and finds ha here is greaer liquidiy when shor-selling is possible. Gao, Hao and Ma (2006) invesigae he shor selling in Hongkong Sock Exchange, and finds ha removing he shor-sale consrains increased he liquidiy of low priced socks bu no high priced ones. Cai and Xia (2006) finds ha he rading of underlying socks become less acive and he informaion asymmery among he invesors aggravaes afer he lif of shor sales consrains in he Hong Kong sock marke, bu hey fail o find any evidence indicaing ha he lif of shor sales consrains seriously desabilizes he marke. 3. Shor Selling in Hong Kong Sock Marke In January 1994, he Hong Kong Sock Exchange (HKEx) inroduced a pilo scheme for regulaed shor selling. Under his scheme, 17 securiies were eligible for shor selling wih up-ick rule. The up-ick rule was repealed in March 1996,

3 and hen reinsaed on Sepember 7, 1998, following he 1997 Asian financial crisis. Moreover, he lis of designaed securiies for shor selling is revised on a quarerly basis by HKEx, based on liquidiy and marke capializaion. 4. Empirical Sudy 4.1. Daa Descripion and Variable Compuaion This sudy uses he daa of shor selling and rading volumes from he websie of HKEx and he daa of Hang Seng index (HSI) from Bloomberg. Because daily shor selling daa have been repored on he websie of HKEx only since February 2004, his sudy covers he period from February 2nd, 2004 o July 31s, The compuaions of he variables used in his sudy are as follows: (1) Measures of shor selling We use daily shor selling volumes (, uni: million shares) as he measuremen of shor selling rading in HKEx. (2) Measures of volailiy We use he daily volailiy of HSI o reflec he volailiy of he marke. H L P P Volailiy = H L ( P + P )/2 Volailiy is he volailiy of HSI on day, PH and PL are he highes and lowes price of HSI on day respecively. (3) Measures of liquidiy Amihud and Mendelson (1991) poins ou ha an asse is liquid if i can be bough or sold a he curren marke price quickly and a low cos. Liquidiy is an elusive concep. I is no observed direcly bu raher has a number of aspecs ha canno be capured in a single measure. Kyle (1985) argues ha marke liquidiy refers o several differen elemens of ransacions coss, including ighness, deph, and resiliency. Harris (1990) argues ha four dimensions of liquidiy can be idenified: widh, deph, immediacy, and resiliency. A widely used proxy for measure of liquidiy in recen empirical sudies is an illiquidiy measure employed by Amihud (2002), which is he daily raio of absolue sock reurn o is dollar volume, averaged over some period. Following Amihud (2002), we consruc an illiquidiy measure o reflec he marke liquidiy indirecly, which is compued as follows: R ln ( P) ln ( P ) Illiquid = = V V 1 Illiqui is he measure of marke illiquidiy on day. I can be inerpreed as he daily price response associaed wih one dollar of rading volume, hus serving as a rough measure of price impac. R is he reurn of HSI on day, P and P-1 are close prices of HSI on day and day -1 respecively, V is he rading volume of he marke (uni: HK$ rillion) on day. Descripive saisics of variables above are summarized in Table 1, and he correlaion marix is presened in Table 2. Table 1 Descripive saisics Variables Mean Sd. Dev. Max Min Volailiy Illiquid Table 2 Correlaion marix Volailiy Illiquid Volailiy Illiquid Saionary Tes To begin wih, a saionary es on he hree daa series is done using he Augmened Dickey Fuller (ADF) es procedure. Table 3 shows ha all he variables are saionary a a convenional level of significance.

4 Table 3 ADF ess resuls Variables (c,,p) ADF AIC Conclusion (c,,4) -5.72*** Saionary Volailiy (c,0,5) -7.69*** Saionary Illiquid (c,0,5) -6.64*** 0.25 saionary Noe: 1. (c,,p) is he model specificaion of ADF es, where c,, p means inercep, rend and lag lengh, respecively. 2. *** denoes significan a he 1% level Granger Causaliy Tess In order o invesigae furher he relaionship beween shor selling and he sock marke volailiy and liquidiy, he widely used causaliy ess firs employed by Granger (1969) are performed here. The noion of Granger causaliy is based on a crierion of incremenal forecasing value. A variable X is said o "Granger cause" anoher variable Y, if "Y can be beer prediced from he pas of X and Y ogeher han he pas of Y alone, oher relevan informaion being used in he predicion". To deermine appropriae lag lenghs for he lag polynomial, we have considered hree differen crieria for specifying he lag lengh a he same ime, which are FPE (Final Predicion Error), AIC (Akaike info crierion) and SC (Schwarz crierion). The resuls of Granger causaliy ess for he shor selling /volailiy /liquidiy relaionship are presened in able 4. Panel A in Table 4 shows evidences of unidirecional causaliy from marke volailiy o shor selling volumes. Tha is, shor selling volumes do no Grangercause marke volailiy. Even if here is abnormal volailiy of marke, i is no caused by shor selling volumes. Panel B in Table 4 shows ha here is a bi-direcional causaliy relaionship beween he shor selling volumes and marke liquidiy. Table 4 Resuls of Granger causaliy ess Null Hypohesis Lag Lengh F-saisics Panel A: Granger causaliy ess for he shor selling / marke volailiy relaionship does no cause Volailiy Volailiy does no cause *** Panel B: Granger causaliy ess for he shor selling / marke liquidiy relaionship does no cause Illiquid *** Illiquid does no cause * Noe: *, **, *** denoes significan a he 10%, 5%, 1% level, respecively Impulse Response Funcion Sims (1980) pus forh he concep of an impulse response o explore he dynamics of an error shock in he sysem on he fuure prediced economic variable. Figure 1 shows ha he marke volailiy has nearly no responses o he innovaion of shor selling volumes, bu he shor selling volumes respond quickly and posiively o he innovaion of marke volailiy. Therefore, from he resuls of Granger causaliy ess and he figures of impulse response funcion, we can conclude ha shor selling volumes do no Granger-cause marke volailiy, bu marke volailiy Granger-causes shor selling volumes. Wih he increase of marke volailiy, shor selling volumes increase oo. To sum up, we find no evidence ha shor selling will make he marke more volaile. Figure 2 shows ha he marke illiquidiy indicaor responds negaively o he innovaion of shor selling volumes from period 2, and he shor selling volumes respond posiively o he innovaion of marke illiquidiy a firs and hen urn o negaive response from period 3. Therefore, we can conclude ha here is a bidirecional causaliy beween shor selling volumes and marke liquidiy. Wih he increase of shor selling volumes, marke liquidiy increase oo. And wih he decrease of marke liquidiy, he shor selling volumes increase a firs and hen decrease laer. To sum up, when shor selling is possible, here is greaer liquidiy of marke.

5 .005 Response of Volailiy o Cholesky One S.D. Innovaions 60 Response of o Cholesky One S.D. Innovaions Volailiy Volailiy Fig. 1 Figures of impulse response funcion for shor selling and marke volailiy.28 Response of Illiquid o Cholesky One S.D. Innovaions 60 Response of o Cholesky One S.D. Innovaions Illiquid Illiquid Fig. 2 Figures of impulse response funcion for shor selling and marke illiquidiy 4.5. Empirical Resuls Analysis In a word, he empirical resuls above indicae ha when shor selling is possible, aggregae sock reurns are less volaile and here is greaer liquidiy of marke. I is migh because ha wih he shor sales resricion, when here are severe imbalances beween sock supply and demand, he marke will flucuae dramaically. However, shor selling mechanism can increase he elasiciy of sock supply. For example, when a sock price is oo high o be reasonable, some raional invesors will undoubedly shor selling his sock, and herefore here is an obviously increase in sock supply in he marke. On he one hand, i will relieve he severe imbalances of supply and demand for his sock. On he oher hand, i will reveal he higher priced signal of his sock o oher invesors, and make he price reurn o reasonable a he end. Furhermore, when he bubble of higher priced sock burss, he shor sellers will repurchase he sock, which has been shor sold, o close heir shor posiions. On he one hand, i will increase he demand of his sock, and he price of i. On he oher hand, i will reveal he lower priced signal of his sock o oher invesors, and hen make he price reasonable a he end. I is by his mechanism ha shor selling can make he marke more sable and liquid. 5. Conclusion and Policy Implicaion In recen years, wih he developmen of sock markes, shor selling has become an imporan componen of basic sock rading sysem. Currenly, shor selling is feasible in mos of he developed markes, and from 1990s he number of emerging markes allowing shor selling has also increased subsanially. Bu here are sill many counries where

6 shor selling is no allowed legally or feasible in pracice, mainly because he policy makers in hese counries worry abou he unfavourable effecs of shor selling on he volailiy and liquidiy of sock markes. However, he empirical findings of his paper reveal ha when shor selling is possible, aggregae sock reurns are less volaile and here is greaer liquidiy. I gives regulaors policy implicaion ha shor selling is no a desabilizing aciviy, bu an accepable form of rading o supply liquidiy even in he absence of marke makers. As o China, shor selling has been allowed officially in Augus 1s, 2006, bu as we know, policy does no necessarily ranslae ino pracice. Unil now, we sill can no sell shor in pracice. As o liquidiy of sock marke, alhough he urnover raes of sock rading in Shanghai and Shenzhen Sock Exchanges are relaively high, if we examine from he perspecive of produc design, micro srucure and marke paricipaors, he liquidiy of our sock marke is relaively lower han ha of oher counry s. Jus as poined ou in a research repor of Shanghai Sock Exchange published on November 22nd, 2006, high urnover raes of sock rading do no necessarily mean high liquidiy of marke. Moreover, his repor argues ha he relaively low liquidiy of Chinese sock marke is mainly due o he imperfecion of marke srucure and rading sysem, and some oher facors of insiuion and regulaion resricions. To sum up, a lo of empirical sudies have found ha removal of shor sales consrains will reduce he volailiy and increase he liquidiy of he marke, and shor selling is imporan o he price discovery funcion of sock marke and he developmen of financial derivaives. Therefore, alhough everyhing has wo sides, shor selling may have some unfavorable impac on he developmen of marke, as long as we can increase he informaion ransparency and regulaion effeciveness, lifing shor selling resricion will have more advanages han disadvanages. Moreover, in he process of esablishing shor selling sysem, we should consider seriously our special financial srucure, developmen level of marke and regulaion abiliy, and adop he mos suiable shor selling rules. 6. References [1] Amihud, Y., 2002, Illiquidiy and Sock Reurns: Cross-secion and Time-series effecs, Journal of Financial Markes 5, [2] Amihud, Y., H.Mendelson, 1991, Liquidiy, Asse Prices and Financial Policy, Financial Analyss Journal 47, [3] Angle, James J., 1997, Shor Selling on he NYSE, Working Paper. [4] Bris, Aruro, William N. Goezmann, and Ning Zhu, 2004, Shor Sales in Global Perspecive, in Frank Fabozzi, ed.: The Theory and Pracice of Shor-Selling. [5] Cai, Jinghan, and Le Xia, 2006, Liquidiy, Informaion Asymmery and Shor Sales Consrains: Evidence from he Hongkong Sock Marke, Working paper. [6] Charoenrook, Anchada, and Hazem Daouk, 2005, A Sudy of Marke- Wide Shor-Selling Resricions, Working Paper. [7] Gao, Pengjie, Jia Hao, and Tongshu Ma, 2006, Does Removing he Shorsale Consrain Improve Liquidiy? Evidence from Hongkong, Working Paper. [8] Granger, C.W.J., Invesigaing causal relaions by economeric models and cross-specral mehods. Economerica, [9] Harris, L.E., 1990, Liquidiy, Trading Rules, and Elecronic Trading Sys-

7 ems, Monograph Series in Finance and Economics. [10] Kyle, A.S., 1985, Coninuous Aucions and Insider Trading, Economerica 53, [11] Liao, Shing-guang, and Chao-jun Yang, 2005, The shor selling mechanism, he marke flucuaion, and he marke fluidiy, Managemen World 12, [12] Liao, Shing-guang, and Chao-jun Yang, 2005, A sudy on he relaionship beween he shor selling and sock price in he securiies marke: evidence from Taiwan sock marke, Journal of Financial Research 10, [13] Liao, Shing-guang, and Zong-xin Zhang, 2005, The shock effec of shor selling mechanism o emerging marke: evidence from Hong Kong sock marke, Journal of Finance and Economics 10, [14] Sim, C., 1980, Macroeconomics and Realiy, Economerica, [15] The Chase Manhaan Bank and he ASTEC Consuling Group, 2000, Shor Selling. [16] Woolridge, J. R., and A. Dickinson, 1994, Shor Selling and Common Sock Prices, Financial Analyss Journal 50, [17] Wu, Shu-kun, and Shi-guang Liao, 2007, The shock effec of margin rading: evidence from Taiwan sock marke, Research Repor of Haiong Securiies Co., Ld.