Put-call parity violations and return predictability: Evidence from the 2008 short sale ban

We investigate the link between stock and options markets during the 2008 U.S. short sale ban. First, we find definitive evidence that the ban indeed caused stock overvaluation. Second, we show that the short sale ban caused a significant increase in put-call parity violations only in the direction of the short sale constraints and it significantly enhanced the stock return predictability of put-call parity violations. Third, the overvaluation is really large. A portfolio formed on the trading signal that the put-call parity violation is in the top quintile underperforms the lowest quintile portfolio by a statistically and economically significant abnormal daily return of 5.6% during the short sale ban period. We employ a novel and rigorous method of using TAQ intraday data to ensure that our high-low violation arbitrage portfolio as well as the five Fama-French factors used to estimate the abnormal returns are implementable by a hypothetical investor exempt from the shorting ban. (C) 2019 Elsevier B.V. All rights reserved.