Handbook of Short Selling

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• Publisher: Academic Press
• Year: 2011
• ISBN:
  9780123877253
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

This comprehensive examination of short selling, which is a bet on stocks declining in value, explores the ways that this strategy drives financial markets. Its focus on short selling by region, its consideration of the history and regulations of short selling, and its mixture of industry and academic perspectives clarify the uses of short selling and dispel notions of its destructive implications. With contributions from around the world, this volume sheds new light on the ways short selling uncovers market forces and can yield profitable trades.

• Combines academic and professional research on short selling in all major financial markets
• Emphasizes details about strategies, implementations, regulation, and tax advantages
• Chapters provide summaries for readers who want up-to-date maps of subject landscapes

Chapter 1. Short Sales and Financial Innovation

How to Take the Good While Avoiding Widespread Default

Graciela Chichilnisky

Contents

1.1 Introduction 4

1.2 Markets with Short Sales 5

1.3 Gains from Trade 6

1.3.1 Market Equilibrium 7

1.4 Social Diversity, Volatility, and Default 8

1.5 Financial Innovation Creates Systemic Risks of Widespread Defaults 9

1.6 Introducing Graduated Reserves 9

1.7 Graduated Reserves Restore Stability and Prevent Default 11

1.8 Conclusion 11

Acknowledgments 12

References 12

This chapter examines the functioning of a market with short sales and provides necessary and sufficient conditions for avoiding volatility and default. When traders are sufficiently diverse, a market with short sales generally fails to reach equilibrium, trading can grow without bounds, leading to volatility and eventually traders default on their contracts. Financial innovation makes things worse because it increases the exposure to default by creating system-wide risks through a cascading effect where default by one trader leads to default by all, (Chichilnisky and Wu, 2006). We show that graduated reserves dampens limits volatility and restores market equilibrium. With the appropriate system of reserves, which are an increasing proportion of the value of trades, traders, by their own choices, limit their positions with respect to each other even though unbounded trades are, in principle, available to them. Graduated reserves can resolve runaway volatility and default in markets with short sales.

Keywords

Default; Financial innovation; Gains from trade; Global cone; Graduated reserves; Limited arbitrage; Market cone; Social diversity; Volatility.

1.1. Introduction

Short sales can enhance market performance and improve a trader's ability to allocate resources. This is their good aspect, and it is known that the welfare gains can be considerable. But increased gains often mean increased risks. Short sales can also lead to market volatility and increase the risk of widespread default, as recent experience has shown as was predicted earlier by Chichilnisky and Wu. This chapter explains the mechanism by which all this happens and shows a practical way to avoid increased volatility and defaults in markets with short sales such as those observed in the US financial crisis of 2008–9.

First we show analytically how volatility and widespread default arise in markets with short sales. When traders are sufficiently diverse, as is rigorously defined here, a market with short sales creates incentives for increasingly long and short trading positions, a situation that can continue unchecked and without limits (Chichilnisky, 1994b). As trading can indeed increase without bounds in a market with short sales, this leads to situations where short sales widely exceed available stocks, for example, where traders leverage 30 or 40 times the value of underlying assets, as occurred recently with CDSs. Therefore, if called, traders cannot cover their positions and have an increasing likelihood of defaulting on their contracts. To add to all this, financial innovation makes things worse by creating systemic risks that magnify individual risks. This was shown rigorously in Chichilnisky and Wu (2006) just prior to and anticipating the 2007 financial crisis—they showed that financial innovation increases market interconnectedness and creates a cascading effect where default by one trader leads to default by many or eventually default by the entire economy. The solution proposed here is an introduction of an appropriate system of graduated reserves that reduces the likelihood of default and restores the market equilibrium in markets with short sales. We show rigorously how graduated reserves dampen the incentives for taking large short-term positions and help stabilize short sales.

Markets with short sales as defined here differ from Arrow–Debreu markets in that traders have no bounds on short sales (Chichilnisky & Heal, 1998). Elsewhere we identified one condition on the diversity of traders’ preferences—or expectations—that is necessary and sufficient for the existence of market equilibrium where the invisible hand delivers consistent and efficient solutions (Chichilnisky, 1991, 1995 and Chichilnisk...

Table of contents

• Cover image
• Table of Contents
• Front Matter
• Copyright
• Preface
• Acknowledgments
• About the Editor
• Contributor Bios
• Chapter 1. Short Sales and Financial Innovation
• Chapter 2. The Goldman Sachs Swaps Shop
• Chapter 3. Off-Shore Short Sales after Morrison
• Chapter 4. Regulating Short Sales in the 21st Century
• Chapter 5. Evolution of Short Selling Regulations and Trading Practices
• Chapter 6. Financing Techniques for Short Sellers
• Chapter 7. A Survey of Short Selling in Canada
• Chapter 8. Are Restrictions on Short Selling Good? A Look at European Markets
• Chapter 9. Short Selling, Clearing, and Settlement in Europe
• Chapter 10. The 2008 Emergency Regulation of Short Selling in the United Kingdom, United States, and Australia
• Chapter 11. Reflections on Short Selling Regulations in Western and Eastern Europe
• Chapter 12. Regulating Short Selling
• Chapter 13. Do Option Prices Reveal Short Sale Restrictions Impact on Banks’ Stock Prices? The German Case*
• Chapter 14. Short Selling in France during the Crisis, the Bans, and What Has Changed since the Euro Correction
• Chapter 15. The Chinese Real Estate Bubble
• Chapter 16. Introduction of Margin Trading and Short Selling in China's Securities Market
• Chapter 17. Impact of Short Selling on China Stock Prices
• Chapter 18. Short Selling the Real Estate Bubble in China
• Chapter 19. Impact of Macroeconomic Indicators on Short Selling
• Chapter 20. New Regulatory Developments for Short Selling in Asia
• Chapter 21. The Signaling of Short Selling Activity in Australia
• Chapter 22. Sourcing Securities for Short Sales
• Chapter 23. Short Selling in Emerging Markets
• Chapter 24. Short Selling and the Problem of Market Maturity in Latin America
• Chapter 25. Short Selling—The Ambrosia or Kryptonite of Emerging Markets?
• Chapter 26. Short Selling Consistency in South Africa
• Chapter 27. Short Selling in Russia
• Chapter 28. Performance Persistence of Short-Biased Hedge Funds
• Chapter 29. An Empirical Analysis of Short-Biased Hedge Funds’ Risk-Adjusted Performance
• Chapter 30. Short Selling by Portfolio Managers
• Chapter 31. Short Selling in an Asset Allocation Framework—The Search for Alpha
• Chapter 32. Machine Learning and Short Positions in Stock Trading Strategies
• Chapter 33. Short Selling Stock Indices on Signals from Implied Volatility Index Changes
• Chapter 34. Short Selling and the Equity Premium Puzzle
• Chapter 35. Affine Term Structure Models and Short Selling
• Chapter 36. Short Sale Constraints in the Equity Market and the Term Structure of Interest Rates
• Chapter 37. Short Selling Assessment Where Consumer Prices Involve Both Currency Trades and Weather Shocks
• Chapter 38. Aggregate Short Selling during Earnings Seasons
• Chapter 39. The Information Content of Short Selling before Macroeconomic Announcements
• Index