Handbook of Short Selling
Handbook of Short Selling
Greg N. Gregoriou
Editor
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Notices
Knowledge and best practice in this field are constantly changing. As new research and experience broaden
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necessary.
Practitioners and researchers must always rely on their own experience and knowledge in evaluating and
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Library of Congress Cataloging-in-Publication Data
Gregoriou, Greg N., 1956-
Handbook of short selling / Greg N. Gregoriou.
p. cm.
ISBN 978-0-12-387724-6
1. Short selling. 2. Speculation. 3. Risk-taking (Psychology) I. Title.
HG6041.G725 2012
332.64'5–dc23 2011020284
British Library Cataloguing-in-Publication Data
A catalogue record for this book is available from the British Library.
For information on all Academic Press publications
visit our Web site at www.elsevierdirect.com
Typeset by: diacriTech, Chennai, India
Printed in the United States of America
111213141516 7654321
Preface
This handbook differs from other edited books because on a global scale it
addresses new rules and regulations about short selling. Quan titative papers
in this book use the latest data available, but more importantly, the papers
are written by well-known academics and money managers.
Many investors believe that short sellers are responsible for market down-
turns, but academic theory does not suggest this. Instead, short sellers
create liquidity in markets and are the best at spotting overpriced stocks as
well as m aking markets more efficient through the aid of p rice discovery.
This short selling handbook comes at a time when financial markets world-
wide are recuperating from the credit crisis and the global c arnage of 2008.
It can assist investors, hedge fund managers, investment analysts, research
analysts, lawyers, account ants, endowments, found ations, and high net
worth i ndividuals to better understand short selling during and after the

crisis of 2008.
The 39 chapters in this handbook will be a valuable source of information
to anyone interested in short selling. Among its most exciting subjects are
views of what the regulators temporarily did to ban shor t selling in o rder to
prevent markets from further collapse. Contributors look both at developed
global markets and emerging markets. They also take up naked short selling,
the ethics of short sell ing, and other important issues.
The first section of the book is devoted to regulation in the United States
with a chapter for Canada. The second section examines both eastern and
western European m arkets, while the third focuses on Japan, China, and
Australia. Section four investigates short selling in Russia and in emerging
marketssuchasinLatinAmericaandSouthAfrica.Thefifthsectionexam-
ines portfolio management and performance of short biased hedge funds,
xvii
short selling by portfolio managers, and more. The last section addresses
modeling, earnings, announcements, and term structure in a short selling
framework. In short, the book does a tour of every c ontinent to investigate
short selling during the recent market meltdown.
For more information see the companion site at evierdirect
.com/companion.jsp?ISBN=9780123877246
xviii Preface
.
Acknowledgments
I thank the handful of anonymous referees during the selection process.
In addition, I also thank J. Scott Bentley, Ph.D., executive finance editor at
Elsevier, for his helpful sugge stions to ameliorate this book, Kathleen Paoni,
editorial project manager as well as Heather Tighe, associate project manager
at Elsevier. I also thank Sol Waksman, president at Barclay Hedge, for sup-
plying hedge fund data for Chapter 29. In addition, we thank PerTrac for
the use of PerTrac Analytics which enabl ed critical parts of our analysis in

Chapter 29. Each contributor is responsible for his or her own chapter.
Neither the editor nor the publisher is responsible for chapter content.
xix
About the Editor
A native of Montreal, Professor Greg N. Gregoriou obtained his Joint Ph.D. at
the University of Quebec at Montreal (UQAM) in Finance which merges the
resources of Montreal’s four major universities UQAM-McGill-Concordia-HEC.
He is Professor of Finance at State University of New York (Plattsburgh).
He has published 43 books, 60 refereed publications in peer-reviewed
journals, and 20 book chapte rs since his arrival at SUNY Plattsburgh in
August 2003. His books have been published by McGraw-Hill, John Wiley
& Sons, Elsevier-Butterworth/Heinemann, Taylor and Francis/CRC Press,
Palgrave-Macmillan, and Risk Books. In addition, his articles have appeared
in the Review of Asset P ricing Studies, Journal of Portfolio Management, Journal
of Futures Markets, European Journal of Operational Research, Annals of Opera-
tions Research, Computers and Operations Research,etc.ProfessorGregoriou
is hedge fund editor and editorial board member for the Journal of Deriva-
tives and Hedge Funds, as well as editorial board member for the Journal of
Wealth Management,theJournal of Risk M anagement in Financial Institutions,
Market Integrity, IEB International Journal of Finance,andtheBrazilian Busi-
ness Review. Professor Gregoriou ’s interests focu s on hedge funds, funds of
funds, and C TAs. He also is Research Associate at the EDHEC Business
School in Nice, France .
xxi
Contributor Bios
Paul U. Ali is an associate professor in the Faculty of Law, University of
Melbourne, and a member of that law faculty’s center for Co rporate Law
and Securities Regulation. Prior to becoming an academic, Paul was, for sev-
eral years, a l awyer in Sydney. Paul has published widely on banking and
finance law, derivatives, securitization,andstructuredfinance,including,in

2009, a book on credit derivatives. Paul has also recently participated in
Joint India-IMF a nd M alaysia-IMF training programs as p art of an IMF
project on derivatives in emerging markets.
DavidE.Allenis a professor of finance a t Edith Cowan University, Perth,
Western Australia. He is the author of three monographs and over 70
refereed publications on a diver se rang e of topics covering corporate finan-
cial policy decisions, asset pricing, business economics, funds management
and performance bench-marking, volatility modeling and hedging, and
market microstructure and liquidity.
Jørgen Vitting Andersen, Ph.D., is a physicist and a senior researcher at
CNRS, University of Nice (France). He has broad international experience
and has worked at the following universities: Paris X (France), McGill
(Canada), Nordita (Denmark), and Imperial College (UK). Over the last
10 years he h as published a series of seminal papers in the new domain
of econophysics, applying ideas from complexity theory to financial
markets.
Paul Brockman is the Joseph R. Perella and Amy M. Perella Chair of
Finance at Lehigh University. He holds a B.A. degree in interna tional studies
from Ohio State University (summa cum laude), an M.B.A. degree from Nova
Southeastern Unive rsity (accounting minor), a nd a Ph.D. in finance (eco-
nomics minor) from Louisiana State University. He received his certified
public accoun tant (CPA) designation (Florida, 1990) and worked for several
years as an accountant, cash ma nager, and futures and options trader. His
xxiii
academic publications have appeared in such journals as the Journal of
Finance, Journal of Financial Economics, Journal of Financial and Quant itative
Analysis, Journal of Banking and Finance, Journal of Corporate Finan ce ,andthe
Journal of Empirical Finance, among others. Pau l has served as a member of
the editorial board for the Journal of Multinational Financial Management and
the Hong Kong Securities Institute’s Securities Journal.

Soufiane Cherkaoui awa its admission to practice law in the state of
New York and is presently an LL.M. d egree candidate in the Fordh am
University School of Law Corporate, Banking and Finance Law program. He
holds a Juris Doctor from Pace University Law School and a B.A. from New
York University.
Graciela Chichilnisky has worked extensively in the Kyoto Protocol process,
creatin g and designing the carbon marke t concept t hat becam e international
law in 2005. She also ac ted as a lead author of the Intergovernmental Panel
on Climate Change, which received the 2007 N obel Prize. A frequent key-
note speaker and special adviser to several UN o rganizations and heads of
state, her pioneering work uses i nnovative mark et mecha nisms to redu ce
carbon emissions, conserve biodiversity and ecosystem services, and improve
the lot of the poor. She is a professor of economics and mathematical statis-
tics at Columbia University and the Sir Louis Matheson Distinguished
Professor at Monash University. Her mo st recent book is Saving Kyoto,coau-
thored with K. Sheeran.
Stefano Corradin is an economist at Europ ean Central Bank, rese arch
division. He earned his B.A. in economics from the University of Verona
(1998), his M.Sc. in economics from CORIPE (1999), and his Ph.D. in busi-
ness administration from the UniversityofCaliforniaatBerkeley(2008).
From 2000 to 2004 he worked in the risk management department of
Cattolica Assicurazioni and Allianz-RAS.
Jeannine Daniel is an investment analyst at Kedge Capital. Prior to joining
Kedge, she worked at Ivy Asset Management, a fund of hedge funds, where
she was charged with coordinating the firm’s European research efforts,
which included the sourcing and investment due dili gence of manag ers
across the various hedge fund strategies. Prior to Ivy, Jeannine worked at
Barclays Global Investors and JP Morgan Chase. She hold s a B.Sc. (Hons) in
business management from the University of London.
Miguel Díaz-Martí nez holds an MBA from the University of Bath and was

a Senior Consultant of the National Planning Department of Colombia
xxiv Contributor Bios
where he analyzed the financial strategies of public companies and
advised the National Government in external debt topics. He has also
held positio ns a s trader and financial an alyst in firms such as Banco San-
tander and ICAP. Miguel holds a Bachelors Degree and a Specialisation
Degree in Finance and Internatio nal A ffairs from the Externado University
in Colombia, and an International De gree in Political Science from the
Institute of Political Studies in Paris.
Elena Dukh ovnaya is a consultant at Ernst & Young in Moscow, one of the
leading international audit and consulting companies. She graduated from
Plekhanov Academy of Economics (Moscow, Russia) with a degree in
economics and mathematics in 2005, and also successfully completed
1 year i n the University of Konsta nz (G ermany) on an exchange program.
She specializes in business, accounting, and regulatory advisory services to
telecommunication and media companies.
Mohamed El Hedi Arouri is currently an associ ate professor of finance at
the University of Orleans, France, and a researcher at EDHEC Business
School. He holds a master’s degree in economics and a Ph.D. in finance
from the University of Paris X Nanterre. His research focuses on the cost of
capital, stock market integration, and international portfolio choice. He
published articles in refereed journals such as Intern ational Journal of
Business, Applied Financial Economics, Frontiers of Finance and Economics, Annals
of Economics and Statistics, Finance, and Economics Bulletin.
Wei Fan obtained his Ph.D. from the University of Electronic Science and
Technology of China, Chengdu Nankai University, Tianjin. He is senior vice-
president of the fixed-income department at Hong Yuan Securities Co. Ltd.
in Beiji ng and is in charge of interest-rate derivatives pricing. He has
authored more than 10 academic papers in the International Financial Review,
Journal o f Financial Transformation, New Mathematics and Natu ral Computation,

Journal of Management (Chinese), and Ope ration and Man age ment (Chinese).
In addition, he has been in charge of two National Natu ral Science Founda-
tion projects and one Securities Associa tion of China projec t. Hi s re search
focuses on asset pricing.
Sihai Fan g obtained his Ph.D. in Economics from Naikai University in
Tianjing, China. He is a Professor of Finance at the University of Electronic
Science and Technology in Chengdu, China. He is a well-known economist in
Mainland China and has published over 100 articles. He is Managing Director
and Chief Economist of Hongyuan Securities, Co. Ltd., in Beijing. His research
area focuses on asset pricing.
Contributor Bios xxv
Dean Fantazzini is an associate professor in econometrics and finance at the
Moscow School of Economics–Moscow State University and visiting profes-
sor at the Higher School of Economics, Moscow. He graduated with honors
from the Department of Economics at the University of Bologna (Italy) in
1999. He obtained a master’s in financial and insurance investments at the
Department of Statistics–University of Bologna (Italy) in 2000 and a Ph.D.
in economics in 2006 at the Department of Economics and Quantitative
Methods, Unive rsity of Pavia (Italy). Before joinin g the Mo scow Sch ool of
Economics, he was research fel low at the Chair for Economics an d Econo-
metrics, University of Konstanz (Germany), and at the Department of Statis-
tics and A pplied Economic s, University of Pa via (Italy). He is a specialist in
time series analysis, financial econometrics, and multivariate dependence in
finance and economics. The author has to his credit more than 20 publica-
tions, including three monographs. On April 28, 2009, he received an award
for productive scientific research and teaching activities by the former USSR
president and Nobel Peace Prize w inner Mikhail S. Gorbachev and by the
MSU rector Professor Viktor A. Sadovnichy.
Emmanuel Fragnière, Ph.D., CIA (certified internal auditor), is a professor
of operations management at the Haute Ecole (HEG) de Gestion de Genève.

He is also a lecturer in m anagement science at the University of Bath’s
school of management. His research interests are modeling languages,
energy and environmental planning, stoc hastic programmi ng, and services
pricing and planning. He has published several papers in academic journals,
such as Annals of Operations Research, Environmental Modeling and Assessment,
Interfaces,andManagement Science. Before joining HEG, was a commo-
dity risk analyst at Cargill (Ocean Transportation) and a senior internal
auditor at Banque Cantonale Vaudoise (risk management and financial
engineering).
Giampaolo Gabbi is a professor of financial investments and risk manage-
ment at the University of Siena and a pro fessor at the SDA Bocconi School of
Management, where he is a risk management unit leader. He coordinates the
M.S c. in finance at the University of Siena and holds a Ph.D. in banking and
corporate management. He has published many books and articles in refer-
eed journals, including Journal of International Financial Markets, Institutions &
Money, Journal of Economic Dynamics and Control, European Journal of Finance,
Managerial Finance, and Journal of Financial Regulation and Compliance.
Paola Giovinazzo is a Ph.D. ca ndidate in finance at the University of Siena.
She studies the regulatory framework of financial markets and the impact
on microstructure.
xxvi Contributor Bios
Russell B. Gregory-Allen is an associate professor of finance in the school
of eco nomics and fin ance at Massey University , where he has been since
December 2004. Prior to coming to New Zealand, he was a portfolio man-
ager for a large pension fund in New York, and before that an assistant pro-
fess or of finance at Rutgers University. His research inte rest s are in issues in
portfolio management and performance measurement.
(Grace) Qing Hao is an assistant prof essor in th e finance d epartment at the
University of M issouri. She is a CFA (charte red fina ncial analy st) ch arter
holder. She holds a M.S. degre e in business f rom t he Unive rsity of Kansas

and a Ph.D. in finance from the University of Florida. She also holds a
bachelor of art, a bachelor of engineering, and a master of engineering from
Tianjin University (China). Grace has published in the Journal of Financial
Econo mics and won the Fama-D FA first prize for the best paper publi shed in
2007 in t he Journal of Financial Economics. She has served as an ad-hoc
revie wer for the Journal of Finance, Journal of Financ ial and Quantitative Analy-
sis, Journal of Banking and Finance, Journal of Corporate Finance, Financial
Review, Journal of Multinational Financial Management, International Review of
Economics and Finance,andResearch in International Business and Finance.
Chinmay Jain is a doctoral candidate in finance at the University of
Memphis. His research interest areas are market microstruc ture and i nternational
finance. He has a book chapter in Project Manager’sHandbookpublished by
McGraw Hill in 2007. He and his coauthors have presented his research papers
in conferences such as the Academy of International Business and Midwest
Finance c onference.
Pankaj K. Jain is the Suzanne Downs Palmer associate professor of finance at
the Fogelman College of Business at the University of Memphis. Previously
he worked in the financial services industry. He has published award-winning
research on financial market design in leading journals such as the Journal of
Finance, Journal of Banking and Finance, Financial Management, Journal of Invest-
ment Management, Journal of Financial Research,andContemporary Accounting
Research. He has been invited to present his work at the New York Stock
Exchange, National Stock Exchange of India, National Bureau of Economic
Research in Cambridge, and the Capital Market Institute at Toronto.
Vicente Jakas is a vice-president in finance global markets at Deutsche Bank
AG, Frankfurt am Main. H e holds a M.Sc. in financial economics from the
University of London (London, UK), a B.A. (honors) in business administra-
tion from the Ro bert Gordon Unive rsity (Aberd een, UK), and a B.Sc. in
business economics from the Universidad de La Laguna (La Laguna, Sp ain).
Contributor Bios xxvii

He has more than 10 years’ experience i n the banking industry and has
worked for the Big Fou r audit and consultancy firms in the area of banking
and finance. His main are as of research are institutions and capital m arkets,
as well as macroeconomic policy and the financial markets.
Fredj Jawadi is currently an assistant professor at Amiens School of Manage-
ment and a researcher at EconomiX at the University of Paris Ouest Nanterre
La Defense (France). He holds a master in econometrics and a Ph.D. in finan-
cial econometrics from the University of Paris X Nanterre (France). H is
research topics cover modeling asset price dynamics, nonlinear econometrics,
international finance, and financial integration in developed and emerging
countries. He has published in international refereed journals, such as Journal
of Risk and Insurance, International Journal of Business, Applied Financial Econom-
ics, Finance,andEconomics Bulletin, and several book chapters.
Meredith Jones is a managing director at PerTrac Financial Solutions. Prior
to joining PerTrac, she was the director o f research for Van Hedge Fund
Advisors. Her research has been published in a number of books and peri-
odicals, and she is a frequent lecturer on a variety of hedge fund topics.
James Kozyra holds a master of science in management, with a concentra-
tion in finance, and is currently a level III candidate in the CFA (chartered
financial an alyst) program. He also earned a honor’s bach elor of commerce
degree, with majors in accounting and finance. His research has been pub-
lished in both academic and practitioner journals.
Akhmad Kram adibrata holds a postgraduat e diploma in finance from Edith
Cowan University and a bachelor of commerce in accounting from Curtin
University of Technology, Perth, Australia. He currently works as a research
assistant in the School of Accounti ng, Finance, and Economics at Edith
Cowan University.
Alexander Kudrov is a researcher at the Higher School of Econom ics
(Moscow, Russia), where he obtained his Ph.D. in economics in 2008. His
main area of research is extreme value theory with applications in econom-

ics and finance, and he has to his credit many publications in Russian math-
ematical journals.
Camillo Lento is a Ph.D. candidate in accounting a t the University of
Southern Queensland. He received both his master’s (M.Sc.) degree and
undergraduate degree (HBComm) from Lakehead University. Lento is a
chartered accountant (Ontario) and a certified fraud examiner. His Ph.D.
xxviii Contributor Bios
researc h investigates the capital market implication of earnings man agement
and earnings quality of firms that meet or beat their earnings expectations.
His research interests also include technical trading models, and he has pub-
lished his research in both academic and practitioner journals. Lento is a
contributing editor for Canadian MoneySaver magazine and has authored
numerous articles on personal tax planning matters. Before embarking on
his Ph.D., he worked in a midsized public accounting firm. He was involved
in various engagements as part of both the assuranc e and business advisor y
services group and the specialist advisory services group.
François-Serge Lhab itant, Ph.D., is cu rrently the chief investment officer at
KedgeCapital.Hewasformerlyamember of senior managem ent at Union
Bancaire Privée, where he was in charge of quantitative risk management and,
subsequently, of quantitative research for alternative portfolios. Prior to this,
Lhabitant was a director at UBS/Global Asset Management, in charge of build-
ing quantitative models for portfolio management and hedge funds. On the
academic side, Lhabitant is currently a professor of finance at the ED HEC
Business School (France) and a visiting professor at the Hong Kong University
of Science and Technology. His specialist skills are in the areas of quantitative
portfolio management, alternative investments (hedge funds), and emerging
markets. He is the author of several books on these subjects and has published
numerous research and scientific articles. He is also a member of the scientific
council of the Autorité des Marches Financiers, the French regulatory body.
Abraham Lioui is a professor of finance at EDHEC Business School and a

member of the EDHEC Risk Institute. He has taught in several institutions,
such as the University of Paris I Sorbonne, ESSEC Business School, and Bar
Ilan University where he was vice chair of the economic department before
joining EDHEC. He has published widely in academic journals in fields
related to portfolio choice theory and asset allocation, derivatives pricing/
hedging, and asset pricing theory.
Marco Lo Duca is an economist at European Central Bank, International
Policy Analysis Division. He earned his B.A. in econom ics from the Uni ver-
sity of Ca’ Foscari, Venice (2002) and his M.Sc. in economics and finance
from the Venice International University (2004). He h as been working at
the European Central Bank since 2004.
Christopher Lufrano is a third-year law student at P ace University Law
School and a student intern for the nonprofit Investor Rights Clinic. Prior to
attending law school, he was an an alyst and fixed income trader with
Morgan Stanley. He holds a B.S. in business from Boston University.
Contributor Bios xxix
Andrew Lynch holds a master’s deg ree in economics from the Unive rsity of
Misso uri and a B.A. in finance and communications from Southwest Baptist
University (summa cum laude). He is a Ph.D. can didate (emphasis in econo-
metrics) in the finance department at the University of Missouri. He has sev-
eral working papers in the areas of short selling, mutual funds, and asset
pricing and has presented them at the Southwestern Finance Association
and the University of Missouri.
Mario Maggi is an assistant professor of mathematical finance at the
University of Pavia. He holds a M.S. in economics from the University of
Pavia and a Ph.D. in mathematical finance from the University of Brescia. He
has held positions at the Universities of Insubria (Varese), Piemonte Orientale
(Alessandria), Bologna (Rimini), and Bocconi (Milano). His research interests
are mathematical finance, decision theory, and numerical methods. He is
author of numerous research papers published in international reviews and

textbooks.
Iliya Markov has a M.Sc. in operational research with f inance from the Uni-
versity of Edinburgh and a B.A. in mathematics and economics f rom the
American University in Bulgaria. His research interests include the financial
and co mmodity markets, financial modeling, and optimization and risk
management. He is a recipient of numerous awards and distinctions, includ-
ing an Outs tanding Achievement in Mathematics at the A merican University
in Bulgaria and a full scholarship at the Univer sity of Edinburgh.
Peter D. Mayall is a lecturer in finance in th e School of Economics and
Finance at Curtin University of Technology in Per th, Wester n Austral ia. His
primary q ualification was in chartered accounting and he worked in
this capacity in his early career in Africa, the Middle East, and the United
Kingdom. He then moved to Australia and changed to the finance industry,
being involved in the assessment and funding of capital projects. He joined
academia in 1993 and lectures in corporate finance, mergers and acquisi-
tions, and financial decision makin g. His research interests include topics of
mergers, agency issues, and the t eaching of finance. He has published in the
area of the teaching of finance.
Stuart McCrary is a director and principal at Navigant Economics. His con-
sulting practice involves traditional and alternative investments, quantitative
valuation, risk management, and financial software. He was president of
Frontier Asset Management, managing a market-neutral hedge fund. He held
positions with Fenchurch Capital Management as senior options trader and
CS First Boston as v ice-president and market maker of over-the-counter
xxx Contributor Bios
options. Prior to that, he was a vice-president with the Securities Groups
and a portfolio manager with Comerica Bank.
Thomas H. McInish is an author or coauthor of more than 100 scholarly
articles in leading journals such as the Journal of Finance, Journ al of Financial
and Quantit ative Analysis, Journal of Portfolio Management, Review of Economics

and Statistics,andSloan Management Review. Cited as one of the “Most Proli-
fic Authors in 72 Finance Jour nals,” he ranked 20 (tie) out of 17,573 indivi-
duals publishing in these journals from 1953 to 2002. Another study
ranked him as 58 out of 4990 acad emics in the number of articles pub-
lished during 1990–2002. His co-authored, path-breaking articles on intra-
day stock market patterns originally published in the Journal of Finance was
selected for inclusion in (1) Microstructure: The Organization of Trading and
Short Term Price Behavior, which is part of the series edited by Richard Roll
of UCLA entitled The International Library of Critical Writings in Financial Eco-
nomic s (this series is a collection of the most important research in financial
economics and serves as a primary research reference for faculty and gradu-
ate students), and (2) Continuous-Time Methods and Market Microstructure,
which is also part of the International Library series.
Qingbin Meng obtained his Ph.D. from Nankai University. He is an assis-
tant professor in the finance department, School of Business, Renmin
University of China, Beijing. He has authored eight academic papers in
SIAM Journal of Control and Optimization, Applied M athematics Computation,
and Statistics and Probability Letters. He is a member of the AFA and was
in charge of two National Social Science Foundation projects and one
Natural Science Foundation pro ject. His research focuses on financial
engineering.
Maryam Meseha is a third-year law student at Pace University School of
Law, anticipating a Juris D octor in May 2011. She received a Bachelor of
Science in international relations from Seton Hall University magna cum
laude. Her professional interests include international business law and com-
mercial arbitration.
Duc Khuong Nguyen is an associate professor of finance and head of the
department of economics, finance, and law at ISC Paris School of Management
(France). He holds a M.Sc. and a Ph.D. in finance from the University of
Grenoble II (France). His principal research areas concern emerging markets

finance, market efficiency, volatility modeling , and risk management in inter-
national capital markets. His most recent articles have been published in
refereed journals such as Review of Accounting and Finance, Managerial Finance,
Contributor Bios xxxi
American Jour nal of Finance and Accounting, Economics Bulletin, Applied Financial
Economics,andBank and Markets.
Andrei Nikiforov is an assistant professor of finance at Rutgers School of Busi-
ness Camden. He holds B.A. and M.A. degrees in geophysics from Perm State
University in Russia (summa cum laude), an M.B.A. degree from the University
of Missouri (summa cum laude), and a Ph.D. in finance from the University of
Missouri. Prior to pursuing his academic finance career, he worked for several
years as a geophys icist modeling and simulating geophysical fields generated
by oil and gas deposits. He published four research articles in geophysical
industry journals. He has presented at FMA and ha s several working papers
investigating the role of earnings seasons on financial markets.
Mehmet Orhan is an associate professor at the econ omics department of
Fatih University, Istanbul, and vice dean of Faculty of Economics and Admin-
istrative Scien ces. He obtained his Ph.D. from Bilkent University, Ankara, and
graduated from the industrial engineering department of the same university.
His main interest includes both theoretical and applied econometrics, and he
has publis hed in Economics Letters, Inter national Journal of Business, Applied Eco-
nomics,andJournal of Economic and Social Research, among others. His theoreti-
cal research interests include HCCME estimation, robust estimation
techniques, and Bayesian inference. He is presently investigating the perfor-
mance of IPOs and hedge funds, value-at-risk, tax revenue estimation, and
international economic cooperation as part of his applied research studies.
Razvan Pascalau joined the school of business and economics at SUNY (State
University of New York) Plattsburgh in 2008. He graduated with a Ph.D. in
economics and a M.Sc. in finance from the University of Alabama. He also
holds a M.Sc. in financial and foreign exchange markets from the Doctoral

School of Finance and Banking in Bucharest, Romania. In 2004, he worked full
time for the Ministry of Fina nce in Romani a as a counselor of European inte-
gration. His primary field of interest is applied time series econometrics with
an emphasis on modeling nonlinear structures in macro and financial data.
His research interests also include topics related to financial risk management,
international finance, and managerial finance/economics. He has published in
Applied Economic Letters, Managerial Finance, Journal of Derivatives and Hedge
Funds, Journal of Wealth Management,andIEB International Journal of Finance.
Edward Pekarek, Esq., is a visiting professor at Pace Law School and the assis-
tant clinic d irector for the nonprofit Pace Investor Rights C linic of John Jay
Legal Services, Inc. He is a former law clerk for the Hon. Kevin Nathaniel Fox,
USMJ, of the U.S. District Court for the Southern District of New York. Pekarek
xxxii Contributor Bios
holds an LL.M. degree in corporate, banking, and finance law from Fordham
University School of Law; a Juris Doctor from Clev eland Marshall Colleg e of
Law; and a B.A. from the College of Wooster, all of which were awarded with
various honors. As a law student, Pekarek coauthored and edited the Respon-
dents’ merit brief in the U.S. Supreme Court matter of Cuyahoga Falls v. Buckeye
CommunityHopeFoundationand an amicus brief in Eric Eldred, et a l. v. John
Ashcroft, Attorney General . He is the former editor in chief of a specialty law
journal and a nationally ranked law school ne wspaper and is the autho r of
numerous academic writings that analyze various financial topics, such as secu-
rities trading, broker–dealer and hedge fund regulation, initial public offerings,
banking mergers, and corporate governance issues. His scholarly work has been
cited by former Securities and Exchange Commission (SEC) Director of
Enforcement Linda Chatman Thomsen, as well as the Levy Economics Institute
of Bard College regarding the banking policy doctrine of “too big to fail” and
by the RAND Institut e for Civil Justice in a report commissioned by the SEC
regarding broker–dealer and investment adviser regulation.
Jack Penm is currently an academic level D at the Australian National

University (ANU). He has an excellent research record in the two disc iplines
in which he e arned his two Ph.D.’ s, one in e lectrical engineering from the
University of Pittsburgh and the other in finance from ANU. He is an
author/coauthor of more than 80 papers published in vario us interna tion-
ally respectful journals.
Robert J. Powell has 20 years of banking experience in South Africa,
New Zealand, and Australia. He has been involved in the d evelopment and
implementation of several credit and financial analysi s models in ba nks. He
has a Ph.D. from Edith Cowan University, where he currently works as a
researcher and senior lecturer in banking and finance.
Mathew J. Ratty is a final year honors stud ent in the Sch ool of Economics
and Finance at Curtin University in Perth, Western Australia. He is also a
research assistant in the department of banking and finance. His honors
dissertation examined Western Australian stock market data and investigated
the effect of director decisions to buy or sell shares on cumulative abnormal
returns.
Simonetta Rosati is a principal market infrastructure expert at the European
Central Bank, based in Frankfurt am Main, Germany. She has contributed to
central banks’ working group in the field of securities settlement systems, cross-
border collateral arrangements, and repo market infrastructures. She has carried
out research in the field of determinants of large-value cross-border payment
Contributor Bios xxxiii
flows, the role on nonbanks in retail payments, comparative analysis of
prudential and oversight regulatory requirements for securities settlement, and
the securities custody industry.
Daniela Russo is the director of general payments and market infrastructure
at the European Central Bank (ECB), based in Frankfurt am Main, Germany.
She chairs or participates in several working groups or committees working in
the field of payment and settlement systems, both at European and global
levels. Some of these groups involve only central banks (e.g., PSSC, CP SS,

CLS, and SWIFT Oversight). Other groups involve central banks and securities
regulat ors (ESCB- CESR, CPSS-IOSCO, T2-S Oversight and Derivatives Re gu-
lators Forum). Other groups also involve participation of the industry
(COGEPS, COGESI, CESAME, MOC, SEPA High Level Group, and EPC).
Houman B. Shadab is an associate professor of law at New York Law
School and an associa te director of its center on financial services law. He is
an internationally recognized expert in financial law and regulation and is
the author of several academic articles on hedge funds and credit derivatives.
He has testified before Congress on the role of hedge f unds in the financial
crisis and also on the compensation of public company executives. Govern-
mental bodies have re cognized his r esearch, wh ich has been cited b y the
Delaware C ourt of Chancery and in studies published by the U.K. House of
Commons and the European Parliament’s Committee on Economic and
Monetary Affairs.
Kym Sheehan,Ph.D.,cametothelawafteravariedcareerinhuman
resource management, where she worked f or private sector organizations in
Australia in executive search, as well as working in the IT and mining indus-
tries. Her primary areas of research interest a re the regulation of executive
compensation via “say on pay” and institutional investor activism.
John L. Simpson is an associate professor in the S chool of Economics and
Finance at Curtin University in Perth, Western Australia. His Ph.D. from the
University of Wester n Australia researched international banking risk models
and his research a reas remain in i nternational banking, finance, and eco-
nomics and in international bu siness risk management. More recently,
research interests include the financial economics of energy. John is well
published in book chapters and internationally referred journals.
Abhay K. Singh is an integrated postgraduate wi th Btech in information
technology and has a M.B.A. in finance from the Indian I nstitute of Infor-
mation Technology & Management, Gwalior, India. He curr ently works as a
xxxiv Contributor Bios

research associate in the School of Accounting, Finance and Economics at
Edith Cowan University.
David M. Smith is an associate professor of finance and director of the Cen-
ter for In stitutional Investment Management at the University at Albany
(State University of New York). He currently serves as associate editor—
finance and accounting fo r the Journal of Business Research.Hereceivedhis
Ph.D. from Virginia Tech and holds the CFA and CMA designations.
M. Nihat Solakoglu is an assistant professor in the banking and finance
department of Bilkent University in Ankara, Turkey. Previously he was an
assistant professor in the Department of Management at Fatih University.
Before joining Fatih University, he worked for American Express in the United
States in international risk management, international information manage-
ment, information and analysis, and fee services marketing departments. He
received his Ph.D. in economics a nd master’s degree in statistics from North
Carolina State University. His main interests are applied finance and interna-
tional finance. His papers have b een published in Applied Economics, Applied
Econo mics Letters, Journal of International Financial Markets, Institutions & Money,
and Journal of Economic and Social Research.
Cristina Sommacampagna is an economist in the risk management division
of the Euro pean Central Bank. She hold s a Ph.D. in m athematics for eco-
nomic decisions from the University of Trieste (2005), a M.Sc. in finance
from CORIPE (2002), and a B.A. in economics from the University of Verona
(2001). From 2006 to 2008 she worked in the financial engineering practice
of Duff & Phelps, LLC, in the San Francisco office. In 2009 she worked in the
risk management department of Commerzbank AG in Frankfurt.
R. De ane T errell is a financial econometrician and officer in the general
division of the Order of Australi a. H e served as vice-chancell or of the ANU
from 1994 to 2000. He has also held visiting appointments at the London
School of Economics, the Wharton School, University of Pen nsylvania, and
the Econometrics Program, Princeton University. He has published a num-

ber of books and research m onographs and around 80 research papers in
leading journals.
Peter T. Treadway is the chief economist of CTRISKS, an Asian-based risk
ratings agency. He had a distinguished car eer on Wall Street and with major
American financial institutions. In 1978–1981 he served as chie f eco no-
mist at Fannie Mae. In 1985–1998, he served as institutional equity analyst
and managing director at Smith Barney following savings and loans
Contributor Bios xxxv
and government-sponsored entities. Treadway was ranked an “all star”
analyst 11 times by Institutional Investor Magazine. He holds a Ph.D. in eco-
nomics from the University of North Carolina at Chapel Hill, an M.B.A.
from New York University, and a B.A. in English from Fordham University
in New Yor k. He served as an adjunct professor of City University of
Hong Kong and Shanghai University of Economics an d Finance.
Nils S. Tuchschmid is currently a professor of banking and finance at Haute
École de Gestion ( HEG), U niversity of Applied S ciences, in Geneva, Switzerland.
He’s also an invited professor of finance a t HEC Lausanne University and
a lecturer at the University of Zurich and U LB in Bruxelles. Tuchschmid is
the author of books and articles on traditional and alternative investments,
on portfolio management, and on the optimal decision-making process. Up
until 1999, he was a professor of finance at HEC Lausanne. Prior to joining
HEG in 2008, he worked for various financial institutions, among o thers
BCV, Credit Suisse, and UBS.
Erik Wallerstein is a research fellow at Haute École de Gestion (HEG),
University of Applied Sciences, in Geneva, Switzerland. He holds a M.Sc. in
applied mathematics from Lund University, Sweden, and a master of
advanced studies in finance from Swiss Federal Institute of Technology Zurich
(ETH) and University of Zurich. At HEG he is working with P rofessor Nils
Tuchschmid on several research projects on hedge funds.
Mark Werman is a Senior Tutor at Massey Unive rsity and has taught ther e

for th e past 15 years. From 1994 to 2003 he taught constitutional law, con-
tract law, and commercial law, and for the past 6 years he has been teaching
finance. Mark has been living in New Zealand for the past 20 years, having
moved to New Zealand from New York. In New York he practiced la w with
his wife, Audrey J. Moss. While living in New York, he was a member of the
board of directors at a local hospital, a performing arts organization, and
nationally recognized philharmonic orchestra. He has a BA in History from
SUNY at Stony Broo k, a JD from Union University Albany Law School, and
an MBA from Auckland University. He is fascinated by financial crises and
scandals and he has been studyin g the current crisis since 2006.
Michael C.S. Wong isaprofessorofCityUniversityofHongKong,spe-
cializing in bank risk management, risk process reengineering, and risk
modeling. From 1998 to 2002 he served as a member of the Education
Committee and FRM Committee of Global Association of Risk Profes-
sionals, pacing the foundation for the success of FRM examination in the
globe. He is also a fo under of CTRISKS Rating, a cred it rating agency for
xxxvi Contributor Bios
Asia. Dr. Wong graduated from University of Cambridge, University of
Essex, and Chinese University of Hong Kong. Prior to his academic and con-
sulting career, he spent 7 years on investm ent ba nking, spec ializing in cur-
rencies, precious metals, and derivatives trading. He mainly teaches MSc,
MBA, and DBA students at the university, with “Teachi ng Exce llence Award”
and “Doctoral Dissertation Award” granted. Dr. Wong has published more
than 50 journal articles and book chapters in Finance and Risk Management
and authored 6 professional books.
Lingqing Xing obtained her master of financial engineering from New York
University. Her area of research is asset pricin g. She has published several
academic papers and has presented at numerous international conferences.
Liu Ya ng obtained her master of business administration (major in finance)
from the Renmin University of China located in Beijing. She is a member of the

treasury system construction team at the headquarters of the China National
Petroleum Corporation. Her research centers on financial management.
Sassan Zaker is a manager of alternative investments at Julius Baer. He joined
Bank Julius Baer & Co. Ltd. in 2004 as head of alternative products and advi-
sory. Before joining Julius, he worked for Swissca Portfolio Management, Fin-
funds Management AG, and UBS. Zaker has 17 years of business experience
in quantitative analysis, portfolio management, and private and institutional
client experience. He holds master’s and Ph.D. engineering degrees from the
Swiss Federal Institute of Technology (ETH) and is also a CFA charter holder.
Kaiguo Zhou is a deputy head and associate professor of the Department of
Finance of Lingnan (University) College of Sun Yat-Sun University in China.
HegraduatedfromCityUniversityofHongKongwithaPh.D.degreein
finance in 2003 and served as visiting fellow of Sloan School of Manage-
ment at MIT in 2006. Zhou has published more than 1 5 journal articles on
China’s financial markets and was granted numerous outstan ding researcher
awards by the university.
Andrew Zlotnik is a private asset managemen t consultant in emerging mar-
kets investments. He started his career as an intern utilities analyst in the
research department of the leading Russian investment bank Troika Dialog.
After this he was a leading economist and a leading risk manager at Moscow
Interbank Currency EXchange. He is a postgraduate student at the Central
Economics and Mathem atics Institute of the Russian Academy of Scie nces.
He holds a B.Sc. degree in economics from Lomonosov Moscow State
University.
Contributor Bios xxxvii
CHAPTER 1
Short Sales and Financial Innovation:
How to Take the Good While Avoiding
Widespread Default
Graciela Chichilnisky

CONTENTS
1.1 Introduction . . 4
1.2 Markets with Short Sales. . . 5
1.3 Gains from Trade. . . . . 6
1.3.1 Market Equilibrium . 7
1.4 Social Diversity, Volatility, and Default 8
1.5 Financial Innovation Creates Systemic Risks of
Widespread Defaults . . 9
1.6 Introducing Graduated Reserves . 9
1.7 Graduated Reserves Restore Stability and Prevent Default . . . . 11
1.8 Conclusion . . . 11
Acknowledgments . 12
References . . . 12
ABSTRACT
This chapter examines the functioning of a market with short sales and
provides necessary and sufficient conditions for avoiding volatility and default.
When traders are sufficiently diverse, a market with short sales generally fails to
reach equilibrium, trading can grow without bounds, leading to volatility and
eventually traders default on their contracts. Financial innovation makes things
worse because it increases the exposure to default by creating system-wide risks
through a cascading effect where default by one trader leads to default by all,
(Chichilnisky and Wu, 2006). We show that graduated reserves dampens limits
volatility and restores market equilibrium. With the appropriate system of
Handbook of Short Selling. DOI: 10.1016/B978-0-12-387724-6.00001-5
© 2012, Elsevier Inc. All rights reserved.
3
reserves, which are an increasing proportion of the value of trades, traders, by
their own choices, limit their positions with respect to each other even though
unbounded trades are, in principle, available to them. Graduated reserves can
resolve runaway volatility and default in markets with short sales.

KEYWORDS
Default; Financial innovation; Gains from trade; Global cone; Graduated
reserves; Limited arbitrage; Market cone; Social diversity; Volatility.
1.1 INTRODUCTION
Short sales can enhance market performance and improve a trader’s ability to
allocate resources. This is t heir good aspect, and it is known that th e welfare
gains can be considerable. But increased gains often mean increased risks.
Short sales can also lead to market volatility and increase the risk of widespread
default, as recent experience has shown as was predicted earlier by Chichilnisky
and Wu. This ch apter explains the m echanism by which all this happens and
shows a practical way to avoid increased volatility and defaults in markets with
short sales such as those observed in the US financial crisis of 2008–9.
First we show analy tically how volatility and widespread defa ult arise in
markets with short sales. When traders are sufficiently diverse, as is rigorously
defined here, a market with short sales creates incentives for increasingly long
and short trad ing positions, a situation that can continue unchecked and
without lim its (Ch ichilnisky, 1994b). As trading can i ndeed i ncrease without
bounds in a mark et w ith short sales, this leads to situations where short sal es
widely exceed available stocks, for example, where traders leverage 30 or 40
times the value of underlying assets, as occurred recently with CDSs.
Therefore, if called, traders cannot cover their positions and have an increas-
ing likelihood of defaulting on their co ntracts. To add to all this, financial
innovation makes things worse by creating systemic risks that magnify indivi-
dual risks. This was s hown rigorously in Chichilnisky and Wu (2006) just
prior to and anticipating the 2007 financial crisis—they showed that financial
innovation increases market inte rconnectedness and creates a cascading effect
where default by one trader leads to default by many or eventually default by
the entire economy. The solution proposed here is an introduction of an
appropriate system of graduated reserves that reduces the likelihood of
default and restores the market equilibrium in markets with short sales. We

show rigoro usly how gr aduated r eserves dampen the incentives for taking
large short-term positions and help stabilize short sales.
Markets with short sales as defined here differ from Arrow –D ebreu m arkets
in that traders have no bounds on short sales (Chichilnisky & Heal, 1998).
4 CHAPTER 1: Short Sales and Financial Innovation
Elsewhere we identified one condition on the diversity of traders’ preferences—
or expectatio ns—that is necessary and sufficient for the exist ence of market
equilibrium where the invisible hand delivers consistent and efficient solutions
(Chichilnisky, 1991, 1994b, 1995; Chichil nis ky & Heal, 1998). Th is chap-
ter goes a step further and shows in practice how the diversity of traders
in markets with sho rt sales c an undermine market equilibrium, inducing
volatility and default that worsen w ith financial innovation. We also show
that through the creation of a graduated reserve s system the problem is
resolved and equilibrium can be restored. With such reserves systems in
place, by their own choice traders tak e bounded positions with respect to
each other even tho ugh unbou nded short sales in principle are available
to them. The German government has recently banned short selling, a pol-
icy t hat is somewhat extrem e and, as shown here, may no t have been
necessary. The conclusion derived here is that short s ales can work wel l,
provided graduated reserves are required—a simple strategy that can pre-
vent runaway volatility and default and restore market equilibrium. The
results reported here are based on prior work by the author and others,
Chichilnisky (1993), Chichilnisky and Heal (1984, 1997), Chichilnisky
and Kalman (1980), Debreu (1954), Lawuers (1993).
1.2 MARKETS WITH SHORT SALES
A competitive market has H ≥ 2 traders and N ≥ 2 commodities that are
traded over time t ∈ R
+
. The consumption of commodities yields utility
uðxðtÞÞ at each period of time t

1
and creates utility paths over time fðtÞ: In
this context, a preference over time is a real valued function U : X → R
+
ranking
utility paths within the space of trading paths available that we take to be a
Hilbert space X as in Chichilnis ky (2 009a, 200 9b, 20 10a, 201 0b).The
vector Ω
h
∈ X represents trader h’s property rights, and Ω = ∑
h
Ω
h
represents
society’s total resources over time.
2
A market has short sales when the trading
1
uðxðtÞÞ∈ R
N
,anduðxÞ: R
N
→R
+
is a concave increasing real valued function that represents instantaneous
utility in period t. Following Chichilnisky (1996a, 1996d, 2009a, 2009b), one views utility paths over
time f ðtÞ= uðxðtÞÞ as elements of an appropriate Hilbert function space X = LðRÞ:
2
We consider general preferences where normalized gradients to indifference surfaces define either
an open or a closed map on every indifference surface, namely (i) indifference surfaces contain no

half-lines, for example, strictly convex preferences, or (ii) normalized gradients to any closed set of
indifferent vectors define a closed set, for example, linear preferences (e.g., Chichilnisky, 1995). The
assumptions and results are ordinal and therefore, without loss of generality, assume U
h
ð0Þ= 0 and
sup
x∈X
U
h
ðxÞ= ∞: Preferences are increasing so that U
h
ðxðtÞÞ> U
h
ðyðtÞÞ when for all t, xðtÞ≥ yðtÞ, and
for a set of positive Lebesgue measure, xðtÞ> yðtÞ: In addition, we assume the traders’ preferences are
uniformly nonsatiated, which means that they can be represented by a utility U with a bounded rate
of increase: for smooth preferences, which are Frechet differentiable, ∃ε, K >0 : ∀x ∈ X, K >‖DUðxÞ‖ > ε:
If a utility function is uniformly nonsatiated, its indifference surfaces are within a uniform distance from
each other: ∀r, s ∈ R, ∃Nðr, sÞ∈ R such that f ∈ U
−1
ðrÞ⇒∃y ∈ U
−1
ðsÞ with ‖f −g‖ ≤ Nðr, sÞ;seeChichilnisky
and Heal (1998). Preferences satisfy either (i) or (ii).
1.2 Markets with Short Sales 5