Does the 2008 short sale ban affect the enforcement of the Law of One Price? Evidence from Australia

Using evidence from pairs trading in Australias equity market, we study the effect of the 2008 worldwide ban on short selling on the Law of One Price (LOP). We find that the ban surprisingly does not hinder the enforcement of the LOP. Violations did arise rather frequently in the turbulent market during the ban period; however, they were subsequently corrected, with prices of close economic substitutes promptly converging to parity. We show that the working of the LOP is not driven by professional arbitrageurs. We suggest that rational, long-only investors are likely to be the enforcer of the LOP, as these investors who are unbound by the ban, simply sell their holdings of stocks that are overpriced relative to their close economic substitutes.