Short-sale constraints: Reductions in costs of capital or overvaluation? Evidence from Hong Kong

We examine the effects of short-sale constraints in Hong Kong where stocks can be shorted only if they are included on an official short-sale list. Using revisions to the list, we test two hypotheses — 1) that short-sale constraints lead to overvaluation and 2) that they lead to lower costs of capital. We find weak support for the Diamond and Verrecchia (1987) version of the overvaluation hypothesis, but more compelling evidence supporting the Xu (2007) version of the overvaluation hypothesis and the cost of capital hypothesis. We argue that in the context of our tests the Xu overvaluation hypothesis is actually a reformulation of the cost of capital hypothesis and that the bulk of our evidence, therefore, supports the notion that short-sale constraints reduce capital costs.

► We study the stock price effects of short-sale constraints in Hong Kong.
► We examine whether constraints lead to overvaluation or to lower costs of capital.
► We find weak support for Diamond and Verrecchia's (1987) overvaluation hypothesis.
► We find stronger support for Xu's (2007) overvaluation hypothesis.
► We find the strongest support for the cost of capital hypothesis.