The Effect of Short Sale Constraint Removal on Volatility in the Presence of Heterogeneous Beliefs

We evaluate the effect of index option initiation on a stock market in which short sales are prohibited. Our focus is the effect on the price volatility of the underlying asset. In a very simple dynamic model with successive generations of single-period investors, we show that volatility can either increase or decrease, depending on the variability of news about final payoffs. As an empirical illustration, we consider data from the Israeli stock market. The data show that volatility increased following the initiation of index options, consistent with the fact that short sales were prohibited in Israel when index options were introduced