Short Selling Restrictions, Transaction Costs, and Stock Returns

Short Selling Restrictions, Transaction Costs, and Stock Returns

This study aims to investigate the effect of short selling restrictions imposed by the Korean government back in 2008 and 2011, on stock returns and their distributions, arbitrage possibilities between KOSPI 200 (KOrea Stock Price Index 200) spot and futures markets, transaction costs, and the size of no-arbitrage band with a 3-regime threshold vector error correction model. Sample period (from April 28, 2003 to May 18, 2012) is divided into 5 sub-samples. Among them, sub-samples 2 and 4 are under short selling restriction. Results are as follows. First, increased volatilities of stock returns are witnessed in short selling restriction periods. On the other hand, the extremely negative returns infrequently appear under short selling restrictions. The latter can indicate the effectiveness of short selling restrictions, but further analyses are needed to figure out the net effect of our government policy on market stability in terms of stock return volatility. Second, the highest transaction cost has been found at the undervaluation regime of KOSPI 200 futures prices of sub-sample 2, and the undervaluation regimes of KOSPI 200 futures prices tend to have higher transaction costs than the overvaluation regimes. Third, sub-sample 2 has the greatest size of 'no-arbitrage band', which indicates the severe limitation of arbitrage profits. The great difficulties to perform a 'short stock-long futures arbitrage strategy' due to short selling restrictions can be the main cause. Fourth, arbitrage profits are really low during the period of short selling restrictions but the rare opportunities for making profit can be captured by 'informed traders' who are willing to pay very high transaction costs. The other periods are easily targeted by arbitragers.