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Heterogeneous Expectations, Short Sales Regulation and the Risk Return Relationship

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  • Jean-François L'Her
  • Jean-Marc Suret

Abstract

This paper examines, in a Canadian context, the effect of short sales regulation on the risk-return relationship. Drawing from Jarrow's work (1980), we derive an equilibrium risk-return relationship that accounts for both heterogeneous expectations and short sales regulation. We conclude that the required rate of return on risky assets in a world where short sales are forbidden is equal to the required rate which would prevail in a world free of short sales restrictions, minus an opportunity cost induced by short sales regulation. We show that, theoretically, this opportunity cost is positively related to the dispersion of agents' beliefs and negatively related to the security's liquidity level. We test the model over the sixty-month period from January 1985 through December 1989 and use 13079 observations (220 companies on average). We pool all the observations into a time series cross-sectional model and use Litzenberger and Ramaswamy's methodology (1979) to address three econometric problems: heteroscedasticity, cross-correlation of disturbance terms and beta measurement errors. The results permit us to establish that a negative linear relationship links expected risky asset returns and the divergence of agents' beliefs. This negative relationship is consistent with the presence of opportunity costs resulting from short sales regulation when return beliefs are heterogeneous. We find that the negative relationship between security returns and dispersion of beliefs is essentially confined to illiquid securities, that is, those monitored by a small number of analysts. Finally, these results are not modified when tested on two sub-periods nor when we introduce two control variables (size, as measured by the number of analysts monitoring the stock, and January effect). L'étude traite de l'effet de la réglementation des ventes à découvert sur la relation rendement-risque, au Canada. ¸ partir du cadre développé par Jarrow (1980), nous développons une expression de la relation rendement-risque lorsque les anticipations des agents sont hétérogènes et les ventes à découvert sont restreintes. Il apparaît alors que les restrictions sur les ventes à découvert induisent un coût d'opportunité qui réduit le taux de rendement anticipé. Ce coût d'opportunité devrait être une fonction positive de la dispersion des anticipations et une fonction négative du niveau de liquidité du titre. Ces hypothèses sont vérifiées à l'aide de données mensuelles, qui couvrent la période de0101 1985 à1101 1989. La méthodologie de Litzenberger et Ramaswamy (1979), est utilisée afin de résoudre les divers problèmes économétriques. Les résultats montrent une relation linéaire négative entre le rendement des titres et le niveau d'hétérogénéité des anticipations, mesuré par la dispersion des prévisions des analystes financiers. Cette relation est surtout observable pour les titres les moins liquides, qui sont ici les moins suivis par les analystes financiers. Ces résultats valent pour chaque sous période et résistent à l'introduction de variables de contrôle.

Suggested Citation

  • Jean-François L'Her & Jean-Marc Suret, 1995. "Heterogeneous Expectations, Short Sales Regulation and the Risk Return Relationship," CIRANO Working Papers 95s-29, CIRANO.
  • Handle: RePEc:cir:cirwor:95s-29
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    References listed on IDEAS

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    1. Fama, Eugene F & French, Kenneth R, 1992. "The Cross-Section of Expected Stock Returns," Journal of Finance, American Finance Association, vol. 47(2), pages 427-465, June.
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    Cited by:

    1. Li, Lianfa & Fleisher, Belton M., 2004. "Heterogeneous expectations and stock prices in segmented markets: application to Chinese firms," The Quarterly Review of Economics and Finance, Elsevier, vol. 44(4), pages 521-538, September.

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    More about this item

    Keywords

    Heterogeneous expectations; Short sales regulation; Dispersion of analysts' forecasts; Anticipations hétérogènes ; Réglementation des ventes à découvert ; Dispersion ; Prévision des analystes;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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