Arbitrage constraints and behaviour of volatility components: evidence from a natural experiment

Abstract

Short-selling constraints are known to impede information flow into the financial markets, particularly that of negative information. We employ “Regulation SHO” as a natural experiment to examine how the lowering of short sale constraints impacts the information flow. Specifically, we investigate whether large and small volatility jumps significantly change around the regulatory change, for the treated (Pilot) and control-group (non-Pilot) stocks. We find that large (small) jumps significantly decline (rise) as an outcome of the relaxation of short sale constraints, despite an increase in the variance of the Pilot stocks. The decline in the intensity of large jumps and the simultaneous increase in the intensity of small jumps suggest more efficient information flow into the market. Furthermore, the decline is larger for firms facing greater short-sale constraints, indicating that the impact of short-sale constraints are more pronounced for them. Implying that the change in the jump components is brought about by the easing of the short sale constraints, we also find that the decline in the large jump intensity is higher for firms with lower con- servatism in information disclosure.