Regulatory Arbitrage using Put-Call Parity

Abstract:     
The conflict between appearance and reality often arises in the law, where it is usually cast as pitting the substance of a transaction against its form. That conflict also arises in finance in the form of the put-call parity theorem, which states that given any three of the following four financial instruments: 1) a riskless zero coupon bond, 2) a share of stock, 3) a call option on the stock, and 4) a put option on the stock - the fourth instrument can be replicated. Thus, the theorem implies that any financial position containing any of those four instruments can be constructed in at least two different ways. Its legal significance arises when economically equivalent holdings receive different legal treatments because they are constructed from different instruments. This article provides several examples of how put-call parity has been used to engage in regulatory arbitrage and discusses the significance of such arbitrage for regulatory policy.

JEL Classifications: G18, G39, H26, K29, L59, N40

Accepted Paper Series