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      Question

      Under the framework of Market Efficiency, short

      selling is most accurately described as a mechanism that ________; however, proponents of the limits to arbitrage theory argue that short selling may fail to correct prices due to ________.
      A Increases noise trading; excessive regulatory oversight from SEBI. Correct Answer Incorrect Answer
      B Mitigates post-earnings announcement drift; the symmetry of information in strong-form efficiency. Correct Answer Incorrect Answer
      C Facilitates the incorporation of negative information into asset prices; high borrowing costs and the risk of a short squeeze. Correct Answer Incorrect Answer
      D Promotes semi-strong efficiency by delaying price discovery; the absence of institutional investors in the derivatives segment. Correct Answer Incorrect Answer
      E Ensures assets are always underpriced; the elimination of systematic risk in the cash segment. Correct Answer Incorrect Answer

      Solution

      In case of efficient markets, shares are fairly priced as prices reflect all available information. They are not overvalued or under priced.   Without short selling, investors who possess negative information cannot act on it unless they already own the stock. Short sellers sell the overvalued shares (by borrowing), in order to make a profit when their prices fall down (when they buy those borrowerd shares from the market at lower prices). Short selling allows the negative or pessimistic information to be priced in, preventing asset bubbles and overvaluation. Therefore, they help in promoting the efficiency of the markets.   While short selling should make markets efficient, in reality, it is risky. If a stock price rises instead of falling, a short squeeze can occur forcing short sellers to buy back shares at high prices. This, combined with high borrowing costs (Stock Lending and Borrowing Mechanism - SLBM fees), acts as a limit to arbitrage, meaning prices may remain inefficiently high for longer than expected. 

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