Put-Call Parity Violations and Return Predictability: Evidence from the 2008 Short Sale Ban

Abstract:     
Using the put-call parity no-arbitrage relation we empirically investigate the link between stock and options markets for the period around the 2008 short sale ban in the US. We document a significant increase in the magnitude of put-call parity violations in the direction of short sale constraints during the ban period relative to both the pre- and post-ban periods. More importantly, we find that the magnitude of these put-call parity violations is a significant predictor of stock returns during the short selling ban period. A portfolio formed on the trading signal that the put-call parity violation is in the top 10% quintile under performs the financial sector index by an average of 3.5% on a daily basis during the ban period. We also show that the short sale ban period is characterized by a rapidly increasing stock implied volatility and higher options market bid-ask spreads, which are accompanied by higher trading volume and open interest. The ratio of put to call open interest increases during the ban period and peaks in the post-ban period, consistent with an increase in the demand for puts relative to calls. Our findings indicate that the implementation of the short sale ban is associated with a decoupling of the stock and options markets, resulting in unintended and undesirable market inefficiencies.

Number of Pages in PDF File: 40

Keywords: short selling ban, put-call parity, return predictability, limits to arbitrage, market efficiency

JEL Classification: G12, G18, G21, G28

working papers series