Short‐sale constraints and informational efficiency to private information: A natural experiment

• Author: Hae Mi Choi
• DOI: http://doi.org/10.1111/fire.12230
• Published date: 01 November 2020
• Date: 01 November 2020

DOI: 10.1111/fire.12230

ORIGINAL ARTICLE

Short-sale constraints and informational efficiency

to private information: A natural experiment

Hae Mi Choi

Quinlan School of Business, LoyolaUniversity

Chicago, Chicago, Illinois

Correspondence

HaeMi Choi, Quinlan School of Business, Loyola

UniversityChicago, 16 E. Pearson St, Chicago, IL

60611.

Email:hchoi2@luc.edu

Abstract

Exploiting a regulatory change in short-sale constraints (Regulation

SHO) as a natural experiment, this paper examines the effect of

short-sale constraints on informational efficiency of stock prices to

private information. I find that short-sellers act as informed traders

prior to forthcoming analyst news and trade on negative private

information. When short-sale constraints are relaxedfor pilot stocks

(treatment group), both trading volume and stock price sensitivity

increase prior to the analyst announcement for bad news but not

for good news, relative to that of nonpilot stocks (control group).

The findings are consistent with the Diamond and Verrecchiamodel

that predicts that short-selling increases the speed of adjustment of

stock prices to private negativeinformation. In the cross-section, the

effect of Reg SHO is stronger in stocks of firms with weak and uncer-

tain information environments (i.e., small firms and firms with high

analyst forecast dispersion).

KEYWORDS

analysts, informational efficiency, private information, regulation

SHO, short-selling, stock price sensitivity

JEL CLASSIFICATIONS

G10, G14, M40

1INTRODUCTION

Short-sellers play an important role in the price discovery process in financial markets. Informed investors who sell

short can incorporate unfavorableinformation about a firm into stock prices. Short-selling activity moves prices closer

to their fundamentals and improves informational efficiency (Diamond & Verrecchia,1987). Consistent with this view,

prior studies suggest that short-selling activity is associated with more efficient price discovery(Boehmer & Wu, 2013;

Reed, 2007).1The literature, however, provides little direct evidence on whether short-selling activity has a causal

effect on stock prices. The difficulty in establishing causality stems largely from the endogenous relation between

1In contrast, Lasser,Wang, and Zhang (2010) find that short interest is not associated with price efficiency. These studies can only suggest an association

betweenshort-selling and price efficiency, as they do not examine changes in short-selling activity.

Financial Review.2020;55:625–643. wileyonlinelibrary.com/journal/fire c

2020 The Eastern Finance Association 625

626 CHOI

stock prices and short-selling activity.In this paper, I use a temporary regulatory experiment on short-sale constraints,

namely Regulation SHO, as a naturalexperiment apparatus to investigate the causal effect of short-sale constraints on

informational efficiency of stock prices in incorporating private information.

Whenthe Securities and Exchange Commission (SEC) adopted Regulation SHO (hereafter Reg SHO) from May 2005

to August 2007, this mandated a temporary suspension of short-sale price tests for a set of randomly selected pilot

stocks. Stocks included in the Russell 3000 Index were rankedby average daily trading volume, and every third stock

wassuspended from the uptick test for the NYSE and the bid test for the NASDAQ. This led to an exogenous decrease in

short-sale constraints and an increase in short-selling activity for the pilot stocks (Angelis, Gurllon, Michenaud, 2013;

Diether, Lee,& Werner, 2009; Grullon, Michenaud, & Weston, 2015; SEC, 2007). Reg SHO provides a natural experi-

mental setting to compare the effect of decreased short-sale constraints for pilot stocks, as stocks were chosen ran-

domly (Fang, Huang, & Karpoff,2015; Ke, Kin, Sheng, & Zhang, 2015; Li, Zhang, 2015).

Tothe best of my knowledge, this is one of the few papers that examine informational efficiency of stock prices in

relation to private information. The two main themes in the short-selling literature are the association between short-

sale constraints on subsequent stock returns (Aitken, Frino,McCorry, & Swan, 1998; Boehmer, Jones, & Zhang, 2008;

Cohen, Diether,& Malloy, 2007; Desai, Ramesh, Thiagarajan, & Balachandran, 2002; Senchack & Starks, 1993), and on

whether short-sellers have valuable private information (Boehmer,Jones, & Zhang, 2015; Christophe, Ferri, & Hsieh,

2010; Desai, Krishnamurthy,and Venkatataman, 2006; Francis,LaFond, Olsson, & Schipper, 2005). This paper connects

thetwo research themes and aims to fill a void by addressing these two issues in the literature. First, I establish causality

(instead of association) of short-sale constraints by exploiting an exogenouschange in short-sale constraints. Second,

this paper examines the impact of Reg SHO on tradingactivity and stock returns prior to analyst announcements, and

thereby,assesses the effect of short-sellers’ private information.

Analysts are important information intermediaries in financial markets who generate and disseminate their pri-

vate information to investors. Negativeanalyst news is associated with significant price declines, and therefore, short-

sellers havestrong incentives to trade prior to negative analyst announcements.2Based on prior studies, I assume that

short-sellers have private information that coincides with that of analysts (partially or in whole), and have incentives

to trade on this information prior to analyst announcements (Boehmer et al., 2015; Christophe et al., 2010). Similar to

Reed (2007), I further assume that this private information becomes public when analyst announcements are made. In

that regard, private information drives short-sellers’ trading activities in the preanalyst-announcement period. During

this pre-announcement period, I examine the changes in trading volume and stock price sensitivity to study informa-

tional efficiency pertaining to private information. It is difficult to observe private information, and accordingly, the

impact of private information has been underexplored in the informational efficiency literature. Prior studies have

mainly focused on the level of shorting prior to public firm announcements and have found mixed evidence, or have

examined the association between short-sale constraints and stock returns after public announcements (e.g.,Arnold,

Butler,Crack, & Zhang, 2005; Reed, 2007).

Themain hypothesis of this study is that relaxed short-sale constraints from Reg SHO increase pessimistic investors’

trading, which in turn, improves informational efficiency in response to forthcoming negative news. This prediction is

based on the theory of Diamond and Verrecchia (1987), which predicts that short-sale constraints reduce the speed

of adjustment of stock prices to negative private information. This study compares the trading volume and the stock

price sensitivity of pilot stocks (the treatment group)—stocks that were randomlychosen by Reg SHO—to that of non-

pilot stocks (the control group), in the period prior to analyst forecast revision announcements. For pilot stocks with

weaker short-sale constraints, I expectthe trading activity of these pessimistic investors to increase prior to negative

revisions but not prior to positive revisions. As a result, short-sellers’ negative private information is incorporated in

2Boehmer, Jones, and Zhang (2015) provide evidence that analyst and earnings-announcement dates are important for individual short-selling activity.

Another benefit of using analyst forecast announcements is that I can identify the type of information (i.e., negative or positive revisions) bycomp aring the

analysts’forecast with their previous forecast.