The effect of short selling and borrowing on market prices and traders’ behavior

Abstract

This paper studies the effect of allowing borrowing and short selling on market prices and traders’ forecasts in an experimental asset market. There are four treatments, organized in a 2 × 2 design based on whether or not margin buying is allowed, and whether short selling is permitted or not. We observe that borrowing and short selling do not have significant effects on prices and forecasts due to extensive within-treatment heterogeneity. Beliefs are based on past prices of the current and previous markets, regardless of borrowing or short selling possibilities. Traders who have greater cognitive abilities tend to make more use of short selling and borrowing. A number of relationships regarding traders’ types, cognitive sophistication, and earnings observed in earlier experimental studies in which borrowing and short selling are not possible, generalize to markets with borrowing and short sales.