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How Does Stock Illiquidity Affect the Informational Role of Option Prices?

60 Pages Posted: 9 Aug 2016 Last revised: 18 Nov 2016

Luis Goncalves-Pinto

Chinese University of Hong Kong - Department of Finance

Jing Xu

School of Finance, Renmin University of China

Date Written: November 17, 2016

Abstract

We uncover a mechanical link in the ability of option prices to predict stock returns. Theoretically, stock illiquidity creates asymmetric hedging costs for puts versus calls, which in turn leads to parity deviations that reveal the expected return of the stock. Empirically, we identify this hedging mechanism by focusing on stocks with zero option volume, and banned stocks during the short-sale ban of 2008, which could only be shorted by option dealers for hedging purposes. We proxy for short-sale costs using the equity lending fees. It is unlikely that our results are driven by informed trading in the options market.

Keywords: Put-Call Parity, Stock Return Predictability, Hedging Costs, Short-Selling

JEL Classification: G11, G12, C13

Suggested Citation

Goncalves-Pinto, Luis and Xu, Jing, How Does Stock Illiquidity Affect the Informational Role of Option Prices? (November 17, 2016). 29th Australasian Finance and Banking Conference 2016. Available at SSRN: https://ssrn.com/abstract=2820422 or http://dx.doi.org/10.2139/ssrn.2820422

Luis Goncalves-Pinto (Contact Author)

Chinese University of Hong Kong - Department of Finance ( email )

Cheng Yu Tung Building
Shatin
Hong Kong
Hong Kong

Jing Xu

School of Finance, Renmin University of China ( email )

59 Zhongguancun Street
Beijing, 100872
China

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