Abstract:*

We analyze the impact of short selling constraints in a setting in which there is uncertainty about the amount of informed traders. We show that price converges to the fundamental value if informed traders do not face significant short selling restrictions. In contrast, when short sellers face large costs, the prices may remain bounded away from fundamentals even when there are arbitrarily many informed traders with noisy private signals. In this case, long run equilibrium prices are determined by (i) the ratio between buy and sell orders; and (ii) prior beliefs. We then analyze a richer framework, where we show that not only rational expectation equilibrium prices do not converge to the fundamental, but also they are path dependent: the equilibrium price will depend on the specific sequence of buy and sell orders (in other words, on a random component).

* (joint with Center for Economic Design)