Mispricing, Short-Sale Constraints, and the Cross-Section of Option Returns
62 Pages Posted: 6 Aug 2020 Last revised: 7 Aug 2020
Date Written: June 1, 2020
Motivated by the theory of demand-based option pricing in imperfect markets, we examine the relation between short-sale constraints and equity option returns, conditional on the level of mis-pricing in the underlying stock. We report a monotonic relation between various measures of short-sales constraints and delta-hedged returns of put options on overpriced stocks. This relation is robust to controls for firm attributes and limits to arbitrage proxies. Our findings suggest that while investors drive up the demand for these put options, dealers command a high premium as compensation for the increased market making risk. We do not find a robust relation for either put options on under-priced stocks or call options.
Keywords: Option Returns; Short Interest; Short Sale Constraints; Mis-Pricing; Limits to Arbitrage
JEL Classification: G12, G13, G14
Suggested Citation: Suggested Citation