Question

When short selling is restricted, are stock prices believed to be misvalued? If so, in which direction (e.g. overvalued or undervalued)? When short selling restrictions are removed, what do we expect will be the effect of the removal on corporate investment? Support your answers with relevant literature and empirical findings.

Answer 1

Price restrictions may impose costs on short sellers in the form of lower fill rates and delays on execution. If these costs are economically significant, then we would expect the removal of the price restrictions to result in increased short selling. We would expect short selling to increase more for pilot stocks than control stocks if the price restrictions are costly, or be the same for the pilot and control stocks if price restrictions are not costly.

Stocks are likely to be more overpriced when short selling constraints are more binding, and when investors disagree more about the stock’s true value.  

Removing price restrictions for the stocks has had an effect on the mechanics of short selling, order routing decisions, displayed depth, and intraday volatility