Mispricing, short-sale constraints, and the cross-section of option returns
Journal of Financial Economics (Forthcoming), vol.
July (3rd Quarter/Summer)
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 mispricing in the underlying stock. We report a monotonic relation between various measures of short-sale 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 underpriced stocks or call options.