SEC Follow Up Exhibits Part C SEC_OEA_FCIC_001760-2501

Reg SHO Pilot Report DRAFT 9/14/2006
pilot and control stocks. We find that quoted depths are augmented by price restrictions but
realized liquidity is unaffected. Further, we find some evidence that price restrictions dampen
short term within-day return volatility, but when measured on average, they seem to have no
effect on daily return volatility.
Finance theory predicts that under certain conditions, constraints on short selling may
cause securities to be misvalued by the market, particularly when investors have highly divergent
opinions about the stock. 14 A simple argument is that short sale constraints make it more costly
for those investors who have a negative opinion of a stock to trade on their beliefs, and thus, their
views may be reflected less in the stock price than those who have a positive view. Under more
general assumptions, theoretic models predict that short sale constraints can cause stocks to be
either overvalued or undervalued. 15 To test whether price restrictions constitute an economically
consequential short sale constraint that influences equilibrium stock prices, we investigate
whether the prices of pilot stocks react in response to the removal of the rule. We find that for
Listed Stocks, control stocks outperform pilot stocks on average by about 24 basis points on the
first day of the Pilot, suggesting that the tick test may cause stocks to be slightly overvalued. For
Nasdaq NM Stocks, no significant return differential was observed surrounding the initiation of
the pilot. We also examine stock returns for a six-month period following the initiation of the
pilot program, to ascertain whether the elimination of price restrictions has had any discernible
effect on stock prices over a longer horizon. We find that pilot stocks and control stocks have
similar returns over this horizon, but some tests show weak evidence consistent with the
hypothesis that price restrictions facilitate over-pricing. In the absence of price restrictions,
prices do not rise as much as with price restrictions, leading to a lower equilibrium price.
14 See, for example, Lintner (1969), Miller (1977), and Scheinkman and Xiong (2003).
15 See Gallmeyer and Hollifield (2006).
Prepared by the Office of Economic Analysis 8
DRAFT