Stock Options, Stock Loans, and the Law of One Price
54 Pages Posted: 8 Mar 2018
Date Written: February 28, 2018
Historically, option market makers were exempt from borrowing shares when short selling which allowed them to hedge their exposure in hard-to-borrow stocks. As a result, options were not redundant securities -- they allowed traders to circumvent short-sale constraints. Regulators removed this exemption in 2008 and in 2013 they prohibited a workaround using 'reverse conversions'. These regulatory changes eliminated the shadow supply of hard-to-borrow shares provided by options; we find that these changes increased the redundancy of option securities and caused a significant increase in equity loan fees. Consequently, market quality has deteriorated: price efficiency is lower and stocks are more overpriced.
Keywords: Equity Options, Short Sales Constraints, Return Predictability, Price Efficiency, Equity Lending Market
JEL Classification: G12, G14
Suggested Citation: Suggested Citation