Can Short-Selling Prohibition Be Optimal?

In the first chapter of this book we listed ten conditions a sale contract should satisfy to be legitimate under Islamic law. In particular, we argued that these conditions prevent short-selling. The reason for this is mainly historical. If legal institutions are not properly developed, short-selling can invite cheating by collecting the fee and not delivering the good or the asset. In modern financial markets the ability to short-sell assets is believed to undermine efficient risk-sharing. Most asset pricing models, for example the Fama-French model, CAPM (capital asset pricing model), APT (arbitrage pricing theory) and their variations, assume that the traders are able to short sell their assets.