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

67 Pages Posted: 9 Aug 2016 Last revised: 4 May 2018

Luis Goncalves-Pinto

Chinese University of Hong Kong - Department of Finance

Jing Xu

Renmin University of China - School of Finance

Date Written: April 26, 2018

Abstract

We argue that deviations from put-call parity can predict stock returns for mechanical reasons unrelated to informed option trading. Theoretically, in the presence of stock trading costs, it is more (less) expensive to replicate call options relative to put options when the price of the underlying stock is more likely to increase (decrease). Empirically, we identify this mechanism by separating the actions of hedgers and speculators using an exogenous short-sale prohibition with a limited exemption for option dealers. We use equity lending fees to proxy for option replication costs, and option order-flow imbalances to rule out the informed trading explanation.

Keywords: Put-Call Parity, Stock Return Predictability, Option Replication, 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? (April 26, 2018). 29th Australasian Finance and Banking Conference 2016; Asian Finance Association (AsianFA) 2018 Conference. 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

Renmin University of China - School of Finance ( email )

59 Zhongguancun Street
Beijing, 100872
China

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