THE EFFECTS OF SHORT-SALES AND LEVERAGE CONSTRAINTS ON MARKET EFFICIENCY

Abstract

This dissertation is a collection of three essays on the effects of short-sales and leverage constraints on market efficiency. The first two essays are single-authored, while the third essay is coauthored with Harrison Hong and Jose Scheinkman.

The first essay investigates what drives momentum crashes. I argue that momentum crashes are due to crowded trades which push prices away from fundamentals leading to strong reversals, and exacerbated by limits of arbitrage due to impediments to short selling. I show that momentum crashes can be avoided in the cross section by shorting only non-crowded losers. There is considerably more short-covering during times when momentum fails. I show using high frequency transactions data that short covering is especially severe in the crowded loser portfolio. A placebo test using a set of 63 futures contracts show that momentum crashes do not exist in futures market after market exposure is correctly hedged, which is consistent with my hypothesis.

The second essay studies the market impact of margin changes in the metals commodity futures market. Using CFTC's proprietary transactional audit trail with detailed account information, I document substantial changes in the composition of traders when a margin change is imposed. Regardless of the direction of margin change, market participants decrease their market exposure after controlling for volatility. Moreover, the effect of margin changes depends on the fraction of traders who are levered, and thus cannot be assessed with public data.

The third essay shows that the short ratio is strongly correlated with a stock's share turnover or liquidity. So highly shorted stocks may simply be easier for arbitrageurs to

cover their shorts and hence to arbitrage. We show that days-to-cover, which divides short ratio by turnover, is a superior measure of binding

short-sales constraints --- stocks with high days-to-cover under-perform the market by 140 basis points per month. And this under-performance has increased significantly over time as the correlation between short ratio and share turnover has gotten more pronounced.