The Effect of Short Sale Constraint Removal on Volatility in the Presence of Heterogeneous Beliefs

We evaluate the effect of short sale constraint removal on a stock market. The intuition is derived from simple geometry. We show that the price curve as a function of the uncertain future payoff changes when investors are able to act on the belief that the price of the share is relatively high. In a very simple model we show that volatility can either increase or decrease, depending on the variability of news about final payoffs. As an empirical illustration, we consider data from the Israeli stock market. The data show that volatility increased following the initiation of index options, consistent with the fact that short sales were prohibited in Israel when index options were introduced. Copyright (c) International Review of Finance Ltd. 2003.

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