| This dissertation investigates the highly controversial topic of the pricing implications of short sale constraints. Many view short selling as a contributing factor to market efficiency, while others consider short sellers responsible for dramatic price declines. This dissertation examines whether short sale constraints are an obstacle to market efficiency and whether these constraints can ensure a lower probability of market crashes.;The first chapter models a market restricted from short selling. Investors have heterogeneous beliefs for the asset values, which causes overpricing as optimists drive prices upwards, while pessimists sit on the sidelines, unable to act on their market views. The main finding is that the magnitude of this overpricing depends not only on the investors' opinion dispersion on the value of the particular asset, but also on the correlation of the particular asset to other assets and the investors' opinion dispersion for the values of those other assets.;The second chapter adjusts the model of Chen, Hong and Stein (2002) to reflect a market with short sale restrictions that indiscriminately bind all investors and stocks. According to model predictions, opinion dispersion leads to overpricing. This hypothesis is empirically tested in the Indian equity market, which provides a natural testing environment, as short sales were banned across the equity market during 2001--2008. Various proxies of opinion dispersion are used, i.e., realized volatility, implied volatility, daily price range, and turnover. Overpricing is measured as the difference between the discounted futures price and the price of the underlying equity index. The empirical results offer supportive evidence of a positive relationship between opinion dispersion and overpricing in a market with short sale constraints.;The third chapter tests empirically Hong and Stein's (2003) theoretical finding, that in an environment of short sale constraints, investor disagreement over future equity prices leads to negatively skewed return distributions. This study uses data from the Indian equity market to examine the third and fourth moments of the return distribution. The skewness of the return distribution is estimated both from realized returns and option prices. Empirical results provide partial supportive evidence for Hong and Stein's (2003) hypothesis. |
