Published online by Cambridge University Press: 02 March 2005
This study examines the effect of short-sale constraints on a stock market, in particular, on stock prices, trading volume, and the relationship between stock price movements and output cycles. The economic model features incomplete markets and heterogeneous agents. The short-sale constraint is endogenously determined in the economy and is a function of agents' risk aversion, time preference, and exogenous driving forces. The dynamic model is solved using a policy function iteration algorithm. We find that, for an array of reasonable time-preference parameters and risk-aversion coefficients, the short sale limits range from 27 to 45% of total outstanding shares. Imposing short-sale constraints causes stock prices to move upward. Trading volume is high when some agents have a large amount of stock holdings but incur a negative shock on their nonfinancial income and is low when some agents have few stock holdings and also incur a negative shock to their nonfinancial income. Stock prices are found to be countercyclical and the expected stock returns are procyclical. These countercyclical stock-price movements are shown to be related to the imposition of a short-sale constraint.