An Option Theoretic Approach to Market Efficiency

Abstract

I use five separate measures of deviation from Put-Call Parity of options on a stock without splits or dividends as separate negative measures for market efficiency. I rely upon the theory of trading volume as a function of short sales costs, etc., and that of market efficiency as a function of trading volume, etc. derived by Bhattacharya (2019). I use Three-Stage Least Squares (3SLS) to estimate this structural system, separately for Nasdaq and non-Nasdaq U.S. stocks. I find, contrary to much previous theoretical and empirical work, that the impact of short sales costs & constraints on market efficiency is not significantly negative and that the impact of trading volume on market efficiency is not significantly positive, and my results are robust to various econometric specifications and financial economic assumptions.

Keywords: Market Efficiency; Short Sales Costs; Short Sales Constraints; Options; Put-Call Parity; Implied Volatility; Volume; Investor Dispersion; Transaction Costs; Market Makers; Market Capitalization; Analysts; Fama-French Factors; Institutional Ownership

JEL Classification: G14; G12; G13; C58; C33; C36