Price Convexity and Skewness
- Author(s): JIANGUO XU
- Published: Sep 04, 2007
- Pages: 2521-2552
- DOI: 10.1111/j.1540-6261.2007.01283.x
This paper develops a model in which investors who are prohibited from short selling agree to disagree on the precision of a publicly observed signal. The model implies that the equilibrium price is a convex function of the public signal. The model predicts that (1) the stock price reacts more to good news than to bad news; (2) the skewness of stock returns is positively correlated with contemporaneous returns, but negatively correlated with lagged returns; (3) short sale constraints increase rather than decrease skewness; and (4) disagreement about information precision increases skewness. Empirical tests conducted find supportive evidence for all these predictions.