Costly short -selling and stock price adjustment to earnings announcements

Abstract

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.