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The Impact of Short-Selling Constraints on Financial Market Stability in a Heterogeneous Agents Model

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Abstract

Recent turmoil on global fi nancial markets has led to a discussion on which policy measures should or could be taken to stabilize financial markets. One such a measure that resurfaced is the imposition of short-selling constraints. It is conjectured that these short-selling constraints reduce speculative trading and thereby have the potential to stabilize volatile financial markets. The purpose of the current paper is to investigate this conjecture in a standard asset pricing model with heterogeneous beliefs. We model short-selling constraints by imposing trading costs for selling an asset short. We find that the local stability properties of the fundamental rational expectations equilibrium do not change when trading costs for short-selling are introduced. However, when the asset is overvalued, costs on short-selling increase mispricing and price volatility.

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Paper provided by Economics Discipline Group, UTS Business School, University of Technology, Sydney in its series Working Paper Series with number 3.

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Length: 41
Date of creation: 01 Feb 2013
Date of revision:
Handle: RePEc:uts:ecowps:3

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Keywords: asset pricing model; heterogeneous beliefs; financial instability; short-selling bias;

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Cited by:
  1. Grosche, Stephanie & Heckelei, Thomas, 2014. "Price dynamics and financialization effects in corn futures markets with heterogeneous traders," Discussion Papers 172077, University of Bonn, Institute for Food and Resource Economics.
  2. Bao, T. & Hommes, C.H. & Makarewicz, T.A., 2014. "Bubble Formation and (In)efficient Markets in Learning-to-Forecast and -Optimize Experiments," CeNDEF Working Papers 14-01, Universiteit van Amsterdam, Center for Nonlinear Dynamics in Economics and Finance.

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