Regulatory Uncertainty and Market Liquidity: The 2008 Short Sale Ban's Impact on Equity Option Markets

65 Pages Posted: 12 Jan 2010  

Robert H. Battalio

University of Notre Dame - Department of Finance

Paul H. Schultz

University of Notre Dame - Department of Finance

Date Written: January 11, 2010

Abstract

We examine how the confusion and regulatory uncertainty generated by the imposition of short sale restrictions in September 2008 impacted equity option markets. We uncover three primary findings. First, investors seeking short exposure in financial stocks did not migrate to the option market to avoid the short sale ban. Second, the short sale restrictions are associated with dramatically increased bid ask spreads for options on banned stocks that are not solely attributable to inflated bid ask spreads on the underlying stocks. We conservatively estimate that over the course of the ban, liquidity demanding investors trading options on banned stocks paid an additional $505 million in transactions costs due to inflated bid ask spreads. Third, synthetic share prices for banned stocks become significantly lower than actual share prices. Our results provide a reminder that regulations imposed in the middle of the night in response to political pressure are likely to have severe unintended consequences.

Keywords: equity option markets, short sales, hedging, bid ask spreads

JEL Classification: G10, G18, G14

Suggested Citation

Battalio, Robert H. and Schultz, Paul H., Regulatory Uncertainty and Market Liquidity: The 2008 Short Sale Ban's Impact on Equity Option Markets (January 11, 2010). Available at SSRN: https://ssrn.com/abstract=1534932 or http://dx.doi.org/10.2139/ssrn.1534932

Robert H. Battalio (Contact Author)

University of Notre Dame - Department of Finance ( email )

P.O. Box 399
Notre Dame, IN 46556-0399
United States
574-631-9428 (Phone)
574-631-5255 (Fax)

Paul H. Schultz

University of Notre Dame - Department of Finance ( email )

P.O. Box 399
Notre Dame, IN 46556-0399
United States
219-631-3338 (Phone)
219-631-5255 (Fax)

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