Put-Call Disparity and Stock Returns: Cross-Section and Time-Series Effects

Abstract

This study examines a market-wide disparity measure based on the systematic deviations from Put-Call parity in the U.S. equity option markets. We show that this dislocation measure provides forward-looking information about market returns and significantly explains the cross-sectional variations of stock returns. Stock returns are negatively related over time to unexpected market dislocation. Our results indicate that investing in the stocks with the largest exposure to the innovations in the disparity measure and shorting the stocks with the smallest generate economically and statistically significant returns. The explanatory power of the disparity measure for the cross-sectional variations of stock returns remain robust after controlling for various liquidity factors and the effects of information asymmetry.

Keywords: Financial Market Dislocation, Il-liquidity, Asset pricing, Return predictability

JEL Classification: G10; G11; G12