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SEC Follow Up Exhibits Part C SEC_OEA_FCIC_001760-2501

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Reg SHO Pilot Report DRAFT 9/14/2006<br />

pilot and control stocks. We find that quoted depths are augmented by price restrictions but<br />

realized liquidity is unaffected. Further, we find some evidence that price restrictions dampen<br />

short term within-day return volatility, but when measured on average, they seem to have no<br />

effect on daily return volatility.<br />

Finance theory predicts that under certain conditions, constraints on short selling may<br />

cause securities to be misvalued by the market, particularly when investors have highly divergent<br />

opinions about the stock. 14 A simple argument is that short sale constraints make it more costly<br />

for those investors who have a negative opinion of a stock to trade on their beliefs, and thus, their<br />

views may be reflected less in the stock price than those who have a positive view. Under more<br />

general assumptions, theoretic models predict that short sale constraints can cause stocks to be<br />

either overvalued or undervalued. 15 To test whether price restrictions constitute an economically<br />

consequential short sale constraint that influences equilibrium stock prices, we investigate<br />

whether the prices of pilot stocks react in response to the removal of the rule. We find that for<br />

Listed Stocks, control stocks outperform pilot stocks on average by about 24 basis points on the<br />

first day of the Pilot, suggesting that the tick test may cause stocks to be slightly overvalued. For<br />

Nasdaq NM Stocks, no significant return differential was observed surrounding the initiation of<br />

the pilot. We also examine stock returns for a six-month period following the initiation of the<br />

pilot program, to ascertain whether the elimination of price restrictions has had any discernible<br />

effect on stock prices over a longer horizon. We find that pilot stocks and control stocks have<br />

similar returns over this horizon, but some tests show weak evidence consistent with the<br />

hypothesis that price restrictions facilitate over-pricing. In the absence of price restrictions,<br />

prices do not rise as much as with price restrictions, leading to a lower equilibrium price.<br />

14 See, for example, Lintner (1969), Miller (1977), and Scheinkman and Xiong (2003).<br />

15 See Gallmeyer and Hollifield (2006).<br />

Prepared by the Office of Economic Analysis 8<br />

DRAFT

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