Limitations of the Black-Scholes Model in China: Short-Selling Constraints and Comparative Analysis with the U.S. and India

The Black-Scholes model revolutionized option pricing under ideal market assumptions (minimal trading friction, no short-selling restrictions…). However, its applicability in emerging markets with critical institutional constraints can be limited. This paper studies how short-selling bans in China violate the Black-Scholes model’s assumptions and cause systematic option mispricing in China.

Regulatory implications for China’s markets, such as Qualified Securities for Short-sale Refinancing program, “T+1” intra-day trading restriction, daily limit on price movements, etc., are studied for their regulatory effects on pricing and arbitrage. The study makes a comparative institutional study on China’s markets with US and India’s markets that have more flexible market settings. the results show that the restrictive settings in China caused a reverse IMVD and driven significant mispricing, whereas US and Indian markets benefit from freer short selling and improved pricing accuracy. The study provides insight for policymakers to carefully expand the short-selling business in mainland China’s capital market, reduce the costs of securities lending, as well as re-arrange trading rules with efficiency as the main target.

This study highlights the influence of market mechanism on the Black-Scholes option pricing theory, as well as inspirations and implications for policymakers seeking more efficient, transparent and deeply liquid derivative markets as well as the capital market.