Shortability and Asset Pricing Model: Evidence from The Hong Kong Stock Market

Abstract

This study explores how the violation of free short selling assumption affects the performance of CAPM and the Fama-French three-factor model, as existing studies show that short-sales constraints affect asset pricing of the stocks. Using data from the Hong Kong Stock Market which has unique regulations on short selling, we conduct both time-series and cross-sectional regression analyses to evaluate the performance of the two models under the short-sales-constraints and the no-constraints market environment. The two models perform much worse in the former environment than in the latter, indicating a significant impact of the short sales constraints on the explanatory power of the models. We then augment the two models with a shortability-mimicking factor. Our results show that the factor has a significant power in explaining both time-series and cross-sectional variation in the size-B/M portfolio returns. The addition of the factor to the two models considerably increases their overall performance.