A theory of price formation in a market with short sale prohibition

Analytically considers an observed turnover anomaly and attributes the findings to the combination of insider trading on asymmetric information and short sale constraints. The sequential trade and firm-specific model is an extension of Easley and O´Hara´s (1992) microstructure model for price formation in a competitive world with informed insiders, market makers and liquidity traders, all being risk-neutral. The results are consistent with the observation of a positive and intertemporal linear relationship between turnover and stock return in the case of an immature market characterized by insider trading (in Thailand). Specifically, stocks with high turnover (or relative trading volume) systematically have positive excess returns due to “good news”; more surprisingly, low turnover stocks systematically have negative excess returns due to “bad news”. A no-trade event is informative and is interpreted as possible evidence of bad news in the market with a short sale prohibition. Using the theory of probabilistic information measures (relative entropy), the model further predicts that the speed with which stocks adjust to lower equilibrium prices will be faster than to higher prices under given conditions. The overall results imply that a short sale prohibition increases market informational efficiency, particularly in the bad news case