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Short-Selling Status and Asset-Pricing Models

Using the uniqueness of Hong Kong regulations on short selling, I find that the CAPM, the Fama-French Three-Factor and the Four-Factor model fare significantly better in capturing the cross-section of expected returns on the stocks which are shortable than the stocks which are not. The results imply that applying the three asset-pricing models to the stocks/markets where short sales are restricted would produce biased estimates. All the three models for portfolios without short-sale constraints have significantly higher R2 and adjusted R2 than for portfolios that are banned to be sold short. This suggests that the three models are much less capable of capturing the average stock returns in the environment of short-sale ban or constraints than in the environment of no such restrictions. This result is generally supported by other measures I use to evaluate the performance of the models, such as the absolute value of alphas and the GRS statistics (except for the four-factor model), and is robust to higher frequency data (weekly data). The implication is that practitioners and academics alike need to be cautious about applying the extant asset-pricing models to circumstances where short-sale restrictions are present in various forms.