Introduction
Conventional wisdom is that the effect of margin trading and short selling on asset prices is subject to country regulations. But the short-selling measure they proposed cannot capture the variance between margin trading and short selling. The time series trading volume comparison between margin trading and short selling is shown in Figure 1.
Our main point focuses on the combined effect of margin trading and short selling on stock misvaluation, rather than on the independent effect of each. However, knowing the effects of margin trading and short selling on stock valuation provides additional motivation for our research goal. Moreover, the situation when performing margin trading and short selling in the market is different.
2014) help reveal the higher price efficiency after lifting the ban on margin trading and short selling. We find that the deviation between margin trading and short selling has a significant positive correlation with the stock misvaluation. The wide spread of margin trading and short selling, the higher the MS index it is.
This finding extends the work of Chang et al. 2014) who investigate the effect of the elimination of margin trading and the prohibition of short selling on price efficiency.
Data sample description and methodology
- Main explanatory variable – MS index
- Dependent variables – misvaluation measures
- Control variables
- Methodology
11 The MS index is defined as the difference in the monthly and quarterly balance7 between margin trading and short selling over the market value of tradable shares. The margin trading balance is the net amount of borrowed money that margin traders hold at a firm after deducting the money repaid. The short selling balance is defined as the net value of the borrowed stock that short sellers hold in a firm after deducting stock redemptions.
The market value of tradable shares is used as the denominator to measure the level of unbalanced information of the pilot program included in share prices. The first one is by Rhodes-Kropf et al. 2005) which estimates the true value of a firm by taking a function of accounting data, including book value of equity, net income and leverage. 𝐿𝐸𝑉 is the leverage ratio, which is defined as the difference between one minus the common equity by total assets.
The estimated dependent variable 𝑀̂𝑖,𝑡 is treated as the intrinsic value of an individual firm in month t. 𝑀𝑆𝑉𝐹 proxies for the degree of deviation between the actual market value and intrinsic value of individual firms. High absolute value of 𝑀𝑆𝑉𝐹 indicates that stocks are very mispriced by investors, and vice versa.
Based on the clean surplus assumption, a company's intrinsic value could be viewed as the sum of its book value and the discounted value of expected residual income. 2006) estimate stock value by predicting an infinite number of future earnings forecasts. 𝐸𝑃𝑆(𝑡) is the earnings per share in period t. 2006), we use the Capital Asset Pricing Model (CAPM) to calculate the annual cost of equity 𝑟𝑒(𝑡). The market risk premium is the average risk premium of the value-weighted market return compared to the risk-free interest rate over the previous five years.
The leverage ratio is defined as the total liability over total assets (Dong et al. 2006). This variable is defined as the sum of the total number of analysts generating stock reports for a company during a given period. Our panel data allows us to apply the fixed panel regression to examine the effect of unbalanced margin trading and short selling on stock misvaluation.
Results
- Summary statistics
- MS index and stock misvaluation relationship
- MS-misvaluation relationship for over- and undervalued firms
- MS-misvaluation relationship for bull and bear markets
- Temporal difference of MS-misvaluation relationship in recent periods
Consistent with the figure reported in the research report13 from Tsinghua University, the margin trading balance contributes much more to the MS index than short selling. Notes: This table reports the fixed effects estimates of the effect of an eligible firm's lagged MS index on its respective error estimates. To be more specific, the increase in the MS index expands the actual company value related to its true value.
However, the positive sign of the MS index can only explain the overall misvaluation of a firm. Therefore, the positive effect of the MS index can affect the overvaluation and undervaluation of a firm in opposite ways. To be more specific, it is not clear whether enhanced overestimation or decreased underestimation is associated with the positive effect of the MS index on both measures of misattribution.
For both valuation groups, we find positive and significant effects of lagged MS index on both malvaluation measures. Notes: This table reports the fixed effect estimates of the effect of an eligible firm's lagged MS index on its respective undervaluation for overvalued and undervalued firms. Notes: This table reports the fixed effect estimates of the effect of an eligible firm's lagged MS index on its respective impairment during bull market periods.
22 Notes: This table reports the fixed effect estimates of the effects of the eligible firm's MS lagged index on its misvaluation during bear market periods. These skilled investors can quickly switch from margin trading to short selling when the market falls, causing the MS Index to decline. We find that the MS index, which carries investor beliefs, reacts sharply to changes in market conditions.
This figure shows the cross-sectional average value of the MS index for eligible margin trading and short-selling firms each month. Notes: This table reports fixed effects estimates of an eligible firm's lagged MS index on its respective misvaluation and the additional impact of the Last Period dummy variable. 26 between the lagged MS index and recent years to examine the effect of the MS index on the misestimation of recent years.
We find that the positive effect of the lagged MS index on both equity undervaluation measures still holds. Furthermore, this table shows a negative effect of the recent period variable and the corresponding interactive term, indicating that the overall positive MS-index effect on stock devaluation appears to be weaker in more recent years.
Robustness check
Notes: This table shows the Dynamic Panel GMM regression and the results of the 2-stage least squares regression of a lagged acceptable MS index on the misvaluation measures (MSVF) of Rhodes-Kropf et al. In panel B, the lagged MS index is instrumented with the corresponding industry average for models 3, 4. Previous analyzes have shown that the lagged MS index can positively and significantly affect stock misvaluation measures.
In previous sections, we have already examined the time structure by including a lagged MS index to analyze the subsequent effect on stock misvaluation. The second concern is about the estimation bias of omitted variables that affect both dependent and independent variables, even if we carefully added control variables from the literature related to stock misvaluation. To address endogeneity concerns, we apply dynamic GMM model regressions and two-stage least squares regressions.
In panel A, we apply the dynamic GMM model that has been used in asset pricing to mitigate endogeneity concerns (e.g. Mellado-Cid et al., 2018; Bofinger et al., 2022). The p-value of AR (3) allows us to reject the serial correlation and thus confirm the validity of the model, which is not over-identified. We treat the industry average of the MS index as an instrument for the pilot program's unbalanced trades.
The industry average has been considered a well-documented instrument variable in the field of stock undervaluation. 2022) use the industry average of sustainable investments to explore stock misvaluation. 2017) argue that peer stocks have similar trading patterns to move with the market. The investor's trading decision should take into consideration the general information of the industry to which the target firm belongs. We expect industry averages to be correlated with the MS index, while they are unrelated to the misstatement measures and error terms.
The positive and significant effect of MS index in models 3 and 4 shows that the two-stage least square regressions alleviate the concern about the omitted variables and further strengthen our results.
Conclusion
The Impact of Margin Trading and Short Selling on Stock Price Efficiency - Evidence from the Fifth Round Ban in the Chinese Stock Market. The asymmetric relationship between initial margin requirements and stock market volatility across bull and bear markets. Behavioral and rational explanations of stock price performance around SEOs: Evidence from a market-to-book ratio decomposition.
