1 SHORT SALE CONSTRAINTS IN THE US EQUITY MARKET AND THE TERM STRUCTURE OF INTEREST RATES. Abraham Lioui EDHEC Business School

2 Reading Questions Do short sale constraints in the equity market matter for the bond market ? Does short sale regulatory uncertainty impact the bond market ? How is the corporate default spread affected by a short sale ban ? Are nominal term spreads for different maturities equally affected by a short ban ? Does the ban matter for the real as well as for the nominal term structure ? What is the impact of the short ban on the volatility of the term structure related variables ? What is the impact of the short ban on the extreme movements in the market ? Can one qualifies the impact of the ban on the bond market as being positive or negative ? What lesson can be drawn for the current debate on regulating the CDS market ? What broad lesson can be drawn for the regulation of financial markets ?

3 Short Sale Definition Short Selling: How does it work ? Who are the short sellers ?

4 Short Sale Banning On 18/19 of September 2008: The SEC banned short selling on the shares of roughly 1000 Financial Institutions; In France, the AMF banned short selling on 15 shares of Financial Institutions; Similar decisions in many countries (UK,…) The coordination was almost perfect.

5 Equity vs. Bonds The bond market was not concerned directly by the ban; Yet, an impact can be expected on investor’s sentiment, risk aversion and this may affect the bond market. Professionals diversify their portfolio between stocks and bonds, this may also impact the bond market. The purpose of this Chapter is to assess these indirect effects.

6 Term Structure Variables DS: the default spread measured as the difference in yield between a Baa and a Aaa long term corporate bond. TS10, TS20 and TS30: nominal term spreads for 10 years, 20 years and 30 years respectively. They are measured as the difference between a bond yield with 10, 20 or 30 years to maturity and the 1 month Treasury Bill yield. IS10 and IS20: inflation related spreads as measured by the difference between the yield on a nominal bond and the corresponding yield on an inflation protected bond.

7 Volatility of Innovations

8 Explaining the Volatility of the Innovations

9 Kurtosis of Innovations

10 Explaining the Kurtosis of the Innovations

11 Conclusion Short sale constraints in the equity market do impact the term structure of interest rates (the two short sale related dummies are statistically significant in our regressions) Both the real and the nominal term structures are affected by the short sale restrictions. Finally, Regulatory uncertainty does also impact the term structure: the impact of the short sale banning is not the same and is contingent to the particular period under scrutiny.