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Failure is an Option Impediments to Short Selling and Options.pdf
Failure is an Option:
Impediments to Short Selling and Options Prices
Richard B. Evans
Christopher C. Geczy
David K. Musto
*
Adam V. Reed
This Version: December 7, 2005
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. Some
of the value of failing passes through to option prices: when failing is cheaper than
borrowing, the relation between borrowing costs and option prices is significantly
weaker. The remaining value is profit to the market maker, and its ability to profit
despite the usual competition between market makers appears to result from a cost
advantage of larger market makers at failing.
*
Evans is from the Carroll School of Management at Boston College. Geczy and Musto are from The
Wharton School at the University of Pennsylvania. Reed is from the Kenan-Flagler Business School at the
University of North Carolina. We gratefully acknowledge important input from an anonymous referee,
Michael Brandt, Greg Brown, Jennifer Conrad, George Constantinides, Patrick Dennis, Darrell Duffie, Bin
Gao, Eitan Goldman, Jonathan Karpoff, Richard Rendleman and seminar participants at Notre Dame, USC,
UT, Wharton and the Western Finance Association Meetings. We thank Wes Gray for excellent research
assistance. The Frank Russell Company generously provided constitution lists for their Russell 3000 index.
Corresponding Author: Adam Reed; Campus Box 3490, McColl Building; Chapel Hill, NC 27514. Phone:
(919) 962-9785. E-mail: adam_reed@.
The ma
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