stockholders not to lend their stock, to prevent short sellers from driving
down the price. In the specific case of Palm, The Wall Street Journalre-
ported that “it may be possible to short sometime next week....The bro-
kerage firms and institutional investors that control much of Palm’s stock
generally agree not to immediately lend the stock to short sellers until
sometime after the IPO date” (March 6, 2000, p. C15).
For institutions that are able to find shares to borrow, the cost of short-
ing is reflected in the interest rate rebate they receive on the short-sale pro-
ceeds. This rebate acts as a price that equilibrates supply and demand in the
securities lending market. The rebate can be negative, meaning that institu-
tions that sell short have to make a daily payment to the lender for the right
to borrow the stock (instead of receiving a daily payment from the lender
as interest payments on the short-sale proceeds). This rebate apparently
only partially equilibrates supply and demand, because the securities lend-
ing market is not a centralized market with a “market-clearing” price. In-
stead, rebates reflect individual deals struck among security owners and
those wishing to short, and these actors must find each other. This search
may be costly and time-consuming (Duffie 1996 suggests that the securities
lending market could be described by a search model).
B. Shorting Costs and OverpricingShort-sale constraints have long been recognized as crucial to the workings
of efficient markets. Diamond and Verrecchia (1987) describe a model with
some informed traders, other uninformed but rational traders, and possible
restrictions on shorting. In their model, although short-sale constraints im-
pede the transmission of private information, short-sale constraints do not
cause any stocks to be overpriced. Uninformed agents rationally take into
account short-sale constraints and set prices realizing that negative opinion
may not be reflected in trading.
With irrational traders, however, short-sale constraints can cause some
stocks to become overpriced. With short-sale constraints, rational arbi-
trageurs can refrain only from buying overpriced stocks, and if there are
enough irrational traders, stocks can be overpriced (see, e.g., Miller 1977,
Russell and Thaler 1985, and Chen, Hong, and Stein 2002). A variety of
evidence is consistent with such overpricing. Figlewski and Webb (1993)
and Dechow et al. (2001) show that stocks with high short interest have
low subsequent returns. Jones and Lamont (2002) show that stocks that
are expensive to short or enter the lending market have high valuations and
low subsequent returns.
Miller (1977) describes how short-sale constraints can cause prices to re-
flect only the views of optimistic investors. In describing the types of stocks
likely to be overpriced because of divergence of opinion, he presciently lists
many of the characteristics of our sample: IPOs with short operating history
MISPRICING IN TECH STOCK CARVE-OUTS 149