RFS Advance Access originally published online on January 5, 2008
Review of Financial Studies 2009 22(5):1955-1980; doi:10.1093/rfs/hhm083
| ||||||||||||||||||||||||||||||||||||||||||||||||||||
Failure Is an Option: Impediments to Short Selling and Options Prices
Darden School at the University of Virginia
The Wharton School at the University of Pennsylvania
Kenan-Flagler Business School at the University of North Carolina
Send Correspondence to Adam Reed, Campus Box 3490, McColl Building, Chapel Hill, NC 27514; phone: (919) 962-9785; E-mail: adam_reed{at}unc.edu.
JEL Classification: G12, G13, G29
 |
Abstract |
|---|
Regulations allow market makers to short sell without borrowing stock, and the transactions of a major options market maker show that in most hard-to-borrow situations, it chooses not to borrow and instead fails to deliver stock to its buyers. A part of the value of failing passes through to options prices: when failing is cheaper than borrowing, the relation between borrowing costs and options prices is significantly weaker. The remaining value is profit to the market maker, and its ability to profit despite competition between market makers appears to result from the cost advantage of larger market makers.
We gratefully acknowledge important input from two anonymous referees, Michael Brandt, Greg Brown, Jennifer Conrad, George Constantinides, Patrick Dennis, Darrell Duffie, Bin Gao, Eitan Goldman, Rick Green, Jonathan Karpoff, Richard Rendleman, Erik Stafford, and seminar participants at Notre Dame, USC, UT, Wharton, and the 2002 Western Finance Association Meetings. We thank Wes Gray and Robert Turnquest for excellent research assistance.