Trading Constraints Impact Stock-Price Movements Differentially
Imposing symmetric trading constraints such as borrowing and shortsale constraints on informed investors will produce asymmetric effects on upward and downward stock-price movements.
ANN ARBOR, Mich.—Stock prices convey important information to investors about the fundamental value of assets. However, new research by a University of Michigan business professor suggests that in cases where trading constraints are imposed, the quality of information conveyed by stock prices is affected by the price level.
In her study of securities trading, Kathy Yuan, assistant professor of finance at Michigan's Stephen M. Ross School of Business, shows that when informed investors are restricted from participating in the market by trading constraints at both high and low asset levels, prices become less informative, prompting uninformed investors to demand an information-disadvantaged premium.
Contrary to expectations that symmetric trading constraints will produce similarly symmetric price movements, Yuan finds that the resulting upward and downward movements of prices are actually quite different. She reports there is a multiplier effect on the downward movement but only a dampening effect on the upward movement.
"My analysis shows that asymmetric price movements are caused by the interaction of information asymmetry between informed and uninformed investors and price-dependent trading constraints," Yuan said. "One implication of this finding is that crashes or large downward price movements are formed much faster than bubbles or large upward price movements."
In her study, Yuan considers two prevalent trading constraints in the financial market: borrowing constraints, which restrict investors when stock prices are low, and shortsale constraints, which bind when prices are high.
When asset prices are low, informed investors are borrowing-constrained, and prices are uninformative about the fundamental value of the assets, she says. Faced with this uncertainty, uninformed investors decrease their demand for the risky assets and require large information-disadvantaged premiums to hold stocks at low price levels. In such cases, information asymmetry has a multiplier effect on downward price movements and may further exacerbate informed investors' borrowing constraints. This can produce sudden price crashes.
Conversely, when informed investors are shortsale-constrained due to high asset prices, prices again become uninformative, according to Yuan. However, in these instances, information asymmetry has a dampening effect on the upward price movement because uninformed investors see deterioration in the quality of information transmitted by the price signals and decrease their demand for the assets, due to adverse selection concerns. Hence, large upward price movements become even less likely.
"In short, our analysis shows that price informativeness varies with the asset level and predicts there will be pronounced asymmetric price movements with symmetric trading constraints," Yuan said.
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