Short-Selling Restrictions and Returns: A Natural Experiment

Restrictions on short-selling may impede market participants from fully expressing their opinions about an asset, causing departures from price efficiency (Miller (1977)). Measuring the impact of short-selling restriction on returns has been elusive because the decision to sell short reflects expectations on returns. We measure the causal impact of short-selling restrictions on returns by taking advantage of an unique dataset and an unique source of exogenous variation in rental fees. In Brazil during the 2010-2013 period rental transaction from individual investors to mutual funds carried an implicit tax discount on days of distribution of Interest on Net Equity (IoNE). The possibility of tax arbitrage produces an exogenous spike in rental fees and short interest during the days surrounding IoNE distribution, making it prohibitively expensive to short-sell for speculative reasons. Our data contains all rental transaction and the identity of the parts, thus allowing us identify transactions for tax arbitrage. We find that the variation of rental fees induced by the tax arbitrage operations has a large impact on abnormal returns, corroborating Miller's hypothesis.