How Does Stock Illiquidity Affect the Informational Role of Option Prices?
59 Pages Posted: 9 Aug 2016 Last revised: 22 Jan 2018
Date Written: January 16, 2018
We show that option prices lead stock prices because of hedging effects rather than informed trading. Theoretically, when the underlying stock is illiquid, it is more (less) costly to replicate a call compared to a put in a good (bad) market state. This creates a mechanical relation between put-call parity deviations and future stock returns. Empirically, we identify this mechanism using the short-sale ban of 2008, when banned stocks could only be shorted by option dealers for hedging purposes. We use equity lending fees and option order imbalances as proxies for short-sale costs and informed option trading, respectively.
Keywords: Put-Call Parity, Stock Return Predictability, Hedging Costs, Short-Selling
JEL Classification: G11, G12, C13
Suggested Citation: Suggested Citation