An Analysis of Market Efficiency in Response to Short Sale Information

Abstract

We investigate the effect of expected short sales and short sales surprises on abnormal securities returns. We then examine the impact of short sales constraints on the informational efficiency of the equity market based on a major hypothesis of Diamond and Verrecchia (1987). We conduct a series of tests using data from a natural experiment created by an SEC-initiated pilot program under the Regulation SHO reform.

We have four major fi…ndings: (1) unexpected bad news, speci…fically, unexpected short sales, cause signifi…cant price adjustment when those unexpected short sales are revealed, (2) surprisingly, expected short sales demand also causes price adjustments after short sales information revelation, (3) short sales surprises have a linear relationship with subsequent abnormal returns, i.e., investors react to different levels of short sales surprises with equal sensitivity, and (4) price tests do not increase short sales constraints in the markets.

Keywords: efficient market hypothesis, rational expectations, short sales volume ratio, short sales constraints, short sales surprise, SEC Reg SHO

JEL Classification: C21, D53, D81, G10, G17