Costly short -selling and stock price adjustment to earnings announcements

We study the effect of short sale constraints on the informational efficiency of stock prices using a direct measure of shot sale constraints. Specifically, we test the Diamond and Verrecchia (1987) hypothesis that short sale constraints reduce the speed at which prices adjust to private information. We show that stocks for which short selling is costly have larger price reactions to earnings announcements, especially to bad news. We confirm the Diamond and Verrechia (1987) prediction that the distribution of announcement day returns is more left skewed and returns have larger absolute values when short selling is constrained. We find that trading volume falls and prices become less informative when short selling is constrained. Furthermore, the fraction of long run price reaction realized on the day of the announcement is smaller when short selling is constrained. *I gratefully acknowledge the comments and suggestions of Richard Evans, Chris Géczy, Gary Gorton, Jeff Jaffe, Alan Lee, Ken Kavajecz, Don Keim, David Musto, Krishna Ramaswamy, Rob Stambaugh, Ro Verrecchia and seminar participants at Arizona State University, the Board of Governors of the Federal Reserve, Emory University, Georgia Tech, HEC Montreal, the University of North Carolina, the University of Pennsylvania, the University of Virginia, and Washington University in St. Louis. Tamala Grissett and Mehmet Orhan provided valuable assistance. All errors are my own. Address correspondence to Adam Reed, Kenan Flagler Business School, The University of North Carolina at Chapel Hill, Campus Box 3490, Chapel Hill, NC 27599 or e-mail: adam_reed@unc.edu. For many years, the effect of short sale constraints has motivated research with important and controversial implications for stock prices. Early papers, such as Miller (1977), argue that short sale constraints prevent pessimistic traders from short selling without restricting optimistic traders from buying, thereby imparting an upward bias to stock prices. In recent years, finance scholars have sought to measure the effects of Miller (1977) and similar models empirically. This article looks at short sale constraints from a different perspective. We characterize the informational efficiency of stock prices in the presence of short sale constraints. Using a timely and accurate measure of short sale constraints, we study the distribution of returns when information is revealed to the public. Diamond and Verrecchia (1987), DV hereafter, sets up a rational expectations model in which market participants take short sale constraints into consideration when formulating their demand and pricing decisions. In the model, short sale constraints lead to a decrease in trading as informed and uninformed traders are prevented from short selling. Since some relatively informative “sell or short” orders are removed from the market, prices take longer to adjust to private information. Price adjustment is particularly slow in the presence of negative private information because informed investors who do not own shares cannot trade on their information, further reducing the number of informative trades. Since securities subject to short sale constraints are slow to incorporate private information, they have relatively large price reactions when private information is publicized. Furthermore, since price adjustment to negative private See Asquith, Pathak, and Ritter (2005), Boehme, Danielsen and Sorescu (2006), Chen, Hong and Stein (2001), Danielsen and Sorescu (2001), Diether Malloy and Scherbina (2002), Jones and Lamont (2002), Nagel (2005), Sorescu (2000), among others, for a discussion of the empirical work. Lamont (2004) reviews the evidence. information is particularly slow, large price reactions are more likely in the presence of bad news, which increases the left skewness of the announcement day return distribution. Previous empirical work has used the introduction of exchange traded options as a proxy for the reduction in short selling costs (i.e. Jennings and Starks (1986), Skinner (1990)). In this paper, we use rebate rates determined in the equity lending market to test the DV hypothesis. To be sold short, stocks are often borrowed in the equity lending market. The borrowing cost fluctuates with market conditions, making some stocks, or specials, temporarily costly to short sell. Using the borrowing cost as an accurate and timely measure of short selling difficulty, we find evidence that supports the DV hypothesis. To measure the efficiency of private information in the presence of short sale constraints, quarterly earnings are taken to be private information until firms announce their earnings to the public. Consistent with the DV prediction that announcement day price reactions will be larger when short selling is constrained, results show that the absolute value of announcement day returns is significantly larger when stocks are on special (0.076 vs. 0.058). We also find that the distribution of announcement day returns is more left skewed when short selling is constrained (measured skewness is 0.228 vs. 4.222), which bears out the DV prediction that large announcement day returns are more likely in the presence of negative information. Furthermore, after controlling for stock characteristics, we find that stocks have larger price reactions and larger announcement day volatilities when short selling is costly. We also find empirical evidence consistent with the mechanism underlying DV. The DV hypothesis hinges on the fact that short sales are removed from the sample of “sell or short” trades when short selling is constrained. We show that volume decreases by an average of 28,442 shares per day when stocks are on special. Furthermore, following Hasbrouck (1993), we decompose returns into informative and transient components. We find that short sale constraints decrease the informativeness of trades by 30%. Furthermore, in a setting where we control for stock characteristics, we find that specialness significantly decreases market quality. In addition to stock price reactions to earnings announcements, we look at the relationship between costly short selling and the post earnings announcement drift anomaly. Papers such as Bernard and Thomas (1989) and Abarbanell and Bernard (1992), document that stocks with extreme earnings surprises tend to drift in the direction of their earnings surprise for periods of up to one year. If the costs of short selling reduce the informational efficiency of private information before the announcement, we might also expect efficiency to be reduced after the information becomes public. In particular, the full incorporation of negative earnings surprises will be delayed. Experiments presented in this paper support this hypothesis; stocks that are on special on the day negative earnings are announced have an abnormal return of -12.8% over the next three months, whereas stocks that are not on special have an abnormal return of 1.2% over the same period. To allow for the possibility of different amounts of post earnings announcement drift in the two samples, we present results comparing the percentage of eventual drift realized on the day of the earnings announcement with and without borrowing constraints. We find that stocks realize 32% less of their eventual post earnings announcement drift on the day of the announcement when short selling is costly. One of the concerns about the effect of costly short selling on stock prices is endogeneity. Since short selling can drive scarcity in the lending market, the short sale constraint measure used in this paper could be problematic private information is driving short selling which, in turn, drives the sort sale constraint. We address this concern in two ways. First, we isolate four corporate events that drive short selling but have nothing to do with private earnings information. These events, mergers, seasoned equity offerings, dividend reinvestment discount programs and initial public offerings, are associated with a sub sample of stock specials for which we can be reasonably certain that the cause of specialness is not related to quarterly earnings. Although the sub sample is small, the distribution of announcement day returns reflects the predictions of the DV hypothesis; the distribution of announcement day returns has a larger average absolute value and more left skewness when short selling is constrained. Second, as a direct test for correlation between private information and specialness, we run a regression of earnings announcement surprises on specialness. We find no relationship, which suggests that stock specials are not associated with private earnings information. The balance of this paper proceeds as follows. Section 1 describes and interprets the equity lending data. Section 2 describes the relationship between this work and existing literature, and Section 3 characterizes our findings. Section 4 concludes. 1. Data One of the largest U.S. securities lenders has generously provided a database describing their daily loan portfolio from November 1, 1998 through October 29, 1999. The database has prices and quantities for the lender’s U.S. equity loans in this period. The rebate rate is a timely measure of short sale constraints. As Table 1 shows, the median loan duration is 3 days, and the mode of the distribution is 1 day. There are 287,838 observations representing new loans, 1,579,763 observations representing changes to existing loans, and 1,617,773 observations representing loans that were extended but otherwise unchanged. Using averaging over multiple loans in a given stock each day, we have 684,007 unique loan rate observations. The database is more fully described in Geczy, Musto and Reed (2002). We construct a measure of specialness from the loan database. Equity loans are priced by the interest rate earned on a borrower’s cash collateral, or the rebate rate. Specialness is the difference between the general rebate rat