How Does Stock Illiquidity Affect the Informational Role of Option Prices?

Abstract

We uncover a mechanical link in the ability of option prices to predict stock returns. Theoretically, stock illiquidity creates asymmetric hedging costs for puts versus calls, which in turn leads to parity deviations that reveal the expected return of the stock. Empirically, we identify this hedging mechanism by focusing on stocks with zero option volume, and banned stocks during the short-sale ban of 2008, which could only be shorted by option dealers for hedging purposes. We proxy for short-sale costs using the equity lending fees. It is unlikely that our results are driven by informed trading in the options market.