Why Large Financial Institutions Buy Put Options from Companies

Abstract:     
This study explores the strategic interaction between large institutional investors and firms that issue put options written on their own stock. The firms experience large positive abnormal annual returns after they sell put options. The vast majority of issued put options expire without being exercised, and the buyers of these options, which are predominantly investment banks, lose money. We propose a model that gives a rationale why an uninformed party, an investment bank will trade in put options with an informed party, the issuing firm, although the expected profits from this trade are negative. The model shows how trading with an informed party can be profitable because the bank can acquire valuable information and afterwards earn abnormal returns on trades in other securities of the same firm. Finally, we outline several predictions from the model, and propose empirical tests to establish our proposition that an investment bank can legally acquire private information and trade profitably on it.

Keywords: Investment banks, put option, screening model

JEL Classifications: G24

Working Paper Series