Positive Return-Volatility Correlation and Short Sale Constraints: Evidence from the Chinese Market

The market price is a convex function of information when short sales are constrained. Borrowing constraints limit investors to bidding up the price. The two effects imply an asymmetric return-volatility correlation (RVC) when information shifts. We build a model to show that: (i) short selling decreases RVC, while margin trading increases RVC; (ii) RVC increases with disagreement; and (iii) RVC increases with returns. The Chinese stock market is ideal for the empirical test because only certain stocks are eligible for short selling and margin trading in the slow policy adoption process. We obtain evidence to support the theoretical predictions correlation.