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

Abstract

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

Ramachandran, Lakshmi Shankar and Tayal, Jitendra, Mispricing, Short-Sale Constraints, and the Cross-Section of Option Returns (June 1, 2020). Journal of Financial Economics (JFE), Forthcoming, Available at SSRN: https://ssrn.com/abstract=3635130 or http://dx.doi.org/10.2139/ssrn.3635130

Lakshmi Shankar Ramachandran

Case Western Reserve University ( email )

10900 Euclid Ave.
Cleveland, OH 44106
United States

Jitendra Tayal (Contact Author)

Ohio University ( email )

Athens, OH 45701
United States

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