92 Risk June 2009

CUTTING EDGE. MARKET RISK

by regulators to put restrictions
on short selling nancial stocks
have had many repercussions for nancial markets. Such restric-
tions are known to lead to overpricing, in the sense used by Jones
& Lamont (2002) stock prices have been pumped up by forced
buying of short positions in the market and have increased mar-
ket volatility.
Te availability of stocks for borrowing depends on market
conditions. Firms usually charge a fee, often in the form of a
reduced interest rate, to accommodate clients who wish to short
hard-to-borrow stocks, so there is a cost associated with main-
taining a short position. While many stocks are easily borrowed,
others are in short supply.
In general, hard-to-borrow stocks earn a reduced interest rate
on cash credited for short positions by the clearing rms. Moreo-
ver, short positions in hard-to-borrow stocks may be forcibly
repurchased (bought in) by the clearing rms. Tese buy-ins will
usually be made in order to cover shortfalls in delivery of stock
following the US Securities and Exchange Commissions Regula-
tion SHO, which requires traders to locate shares of threshold
securities that they intend to short before doing so. Although a
stock may have a large short interest the percentage of the oat
currently held short without actually being subject to buy-ins,
hard-to-borrow stocks are those for which buy-ins will occur with
non-zero probability. Te larger the short interest, the harder it is
to borrow stock.
When a buy-in takes place, rms repurchase stock in the
amount of the undelivered short positions of their clients. Tis
introduces an excess demand for stock that is unmatched by sup-
ply at the current price, resulting in a temporary upward impact
on prices. Each day, when buy-ins are completed, the excess
demand disappears, causing the stock price to jump roughly to
where it was before the buy-in started (see gure 1). We note that
the short interest and the buy-in rate should vary in the same
direction: the greater the short interest, the more frequent the
buy-ins. Te more frequent the buy-ins, the higher the stock price
gets driven by market impact.
A critical consideration is that shorting stock and buying puts
are not equivalent as a means of gaining short exposure. A trader
subject to a potential buy-in remains uncertain of how much, if
any, of his short position might be repurchased until the market
closes, and will have to sell any unexpected long deltas acquired
through buy-ins. As a consequence, someone who is long a put
will not have the same synthetic position as the holder of a call
and short stock. Te latter position will reect an uncertain
amount of short stock overnight but not the former. Te follow-
ing examples illustrate the rich variety of phenomena associated
with hard-to-borrow stocks, which we will attempt to explain
with our model.
N Articially high prices and sharp drops. Over a period of
less than two years, from 2003 to 2005, the stock of Krispy
Kreme Doughnuts (KKD) made extraordinary moves, rising
from single digits to more than $200. During this time, buy-ins
were quite frequent. Short holders of the stock were unpredictably
forced to cover part of their shorts by their clearing rms, often at
unfavourable prices. After 2005, KKD failed to report earnings
for more than four consecutive quarters, several members of the
original management team left or were replaced, and the stock
price dropped to less than $3.
N Short-squeezes. A short-squeeze is often dened as a situa-
tion in which an imbalance between supply and demand causes
the stock to rise abruptly and a scramble to cover on the part of
short sellers. Te need to cover short positions drives the stock
even higher. In a recent market development, Porsche indicated
its desire to control 75% of Volkswagen, leading to an extraor-
A dynamic model for
hard-to-borrow stocks
Traders with short positions in stocks that are subject
to short-selling restrictions risk being bought in, in
the sense that their positions may be closed out by
the clearing frm at market prices. Marco Avellaneda
and Mike Lipkin present a model for the dynamics of
these hard-to-borrow stocks, concluding that such
restrictions result in increased volatility, and modifed
put-call parity and option pricing
Recent moves
1
Premium-over-parity (POP) means the dierence between the (mid-)market price of the option and its
intrinsic value. Some authors also call the POP the extrinsic value. We use approximately equal because
listed options are American-style, so they have an early exercise premium. Nevertheless, at-the-money
options will generally satisfy the put-call parity equation within narrow bounds
avellaneda.indd 92 27/5/09 11:34:59
risk.net 93
dinary spike in the stock price (see gure 2).
N Cost of conversions. Converting means selling a call option
and buying a put option of the same strike and 100 shares of
stock. According to put-call parity, for an ordinary (non-divi-
dend paying) stock, the premium-over-parity of a call (C
pop
)
should exceed the premium-over-parity of the corresponding
put (P
pop
) by an amount approximately equal to the strike times
the spot rate.
1
In particular, a converter should receive a credit
for selling the call, buying the put and buying 100 shares.
However, for hard-to-borrow stocks the reverse is often true.
In January 2008, prior to announcing earnings, the stock of
VMWare Corporation (VMW) became extremely hard to bor-
row. Tis was reected by the unusual cost of converting on the
January 2009 at-the-money strike. Te dierence C
pop
P
pop
for the January 2009 $60 line was $8! A converter would
therefore need to pay $8 (per share) to enter the position, that
is, $800 per contract.
Following the earnings announcement, VMW fell roughly $28
(see gure 3). At the same time, the cost of the conversion on the
60 strike in January 2009 dropped in absolute value to approxi-
mately $1.80 (per share) from $8. (Te stock was still hard to
borrow, but much less so.) Terefore, a trader holding 10 puts,
long 1,000 shares and short 10 calls, believing himself to be delta-
neutral, would have lost ($8 $1.80) 10 100 = $6,200.
N Unusual pricing of vertical spreads. A vertical spread (see
Natenberg, 1998) is dened as buying an option with one strike
and selling another with a dierent strike on the same series.
Options on the same hard-to-borrow name with dierent strikes
and the same expiry seem to be mis-priced. For example, the bio-
tech company Dendreon was extremely hard to borrow in Febru-
ary 2008. With stock trading at $5.90, the January 2009 $2.50
5.00 put spread was trading at $2.08 (midpoint prices), shy of a
maximal value of $2.50, despite having zero intrinsic value.
Notice this greatly exceeds the midpoint-rule value of $1.25,
which is typically a good upper bound for out-of-the-money ver-
tical spreads buying an option with one strike and selling
another with a dierent strike.
To recover these features within a mathematical model, we pro-
pose a stochastic buy-in rate that provides a feedback mechanism
coupling the dynamics of the stock price with the frequency at
which buy-ins take place, measured in events per year. We model
the temporary excess demand as a drift proportional to the buy-in
rate and the relaxation as a Poisson jump with intensity equal to
the buy-in rate, so that, on average, the expected return from
holding stock that is attributable to buy-in events is zero. Using
this process, we derive option pricing formulas and describe many
empirical stylised facts. Te model presented here can be seen as
providing a dynamic framework for quantifying market-makers
losses due to buy-ins, as in the recent empirically focused article
by Evans et al (2008), and adds to a considerable amount of previ-
ous theoretical work on hard-to-borrow stocks, for example in
Nielsen (1989), Due, Garleanu & Pedersen (2002) and Dia-
mond & Verrecchia (1987).
After introducing the model in the following section, we derive
a corresponding put-call parity relation matching the observed
conversion prices. Te anomalous vertical spreads are also
explained. Ten we present option pricing formulas for Euro-
pean-style options and tractable approximations for American-
style options. One of the most striking consequences is the early
exercise of deep in-the-money calls. Ten we observe that the
uctuations in the intensity of buy-ins and changes in the cost of
25
27
29
31
33
35
37
39
41
43
I
O
C

(
$
)
1
84
167
250
333
416
499
582
665
748
831
914
997
1,080
1,163
1,246
1,329
1,412
1,495
1,578
1,661
Note the huge spike, which occurred on the closing print of
June 19. The price retreats nearly to the same level as prior to
the buy-in
1 Minute-by-minute price evolution of Interoil
Corporation: June 1723, 2008
0
20
40
60
80
100
120
140
V
M
W

(
$
)
Nov
2007
Dec Jan
2008
Feb Mar Apr May Jun Jul Aug Sep
Note: the large drop in price after an earnings announcement in late
January 2008 was accompanied by a reduction in the difficulty to
borrow, as seen in the price of conversions
3 Closing prices of VMWare: November 1, 2007
September 26, 2008
0
100
200
300
400
500
600
700
800
900
1,000
V
o
l
k
s
w
a
g
e
n
(

)
September October Nov
2 Short-squeeze in Volkswagen: October 2008
avellaneda.indd 93 27/5/09 11:35:00
94 Risk June 2009
CUTTING EDGE. MARKET RISK
borrowing can be measured using leveraged exchange-traded
funds (ETFs) tracking nancial stocks (which were extremely
hard to borrow in autumn 2008).
The model
We assume that under the physical measure the hard-to-borrow
stock S
t
and buy-in rate i
t
satisfy the system of coupled equations:
dS
t
S
t
odW
t
+ yi
t
dt ydN
i
t
t ( ) (1)
dX
t
xdZ
t
+ o X X
t
( )dt +
dS
t
S
t
, X
t
ln i
t
/ i
0
( ) (2)
where dN
i
(t) denotes the increment of a standard Poisson process
with intensity i
t
over the interval (t, t + dt); the parameters o and
y are respectively the volatility of the continuous part and the
price elasticity of demand due to buy-ins; and W
t
is a standard
Brownian motion. Equation (2) describes the evolution of the
logarithm of the buy-in rate; x is the volatility of the rate, Z
t
is a
Brownian motion independent of W
t
, X
_
is a long-term equilib-
rium value for X
t
, o is the speed of mean-reversion and couples
the change in price with the buy-in rate.
We assume that > 0; in particular, X
t
= ln(i
t
) is positively cor-
related with price changes, introducing a positive feedback
between increases in buy-ins (hence in short interest in the stock)
and price.
Equations (1) and (2) describe the evolution of the stock price
across an extended period of time. One can think of a diusion
process for the stock price, which is punctuated by jumps occur-
ring at the end of the trading day, the magnitude and frequency
of the latter being determined by i
t
. Fluctuations in i
t
represent
the fact that a stock may be dicult to borrow one day and easier
another. In this way, the model describes the dynamics of the
stock price as costs for stock-loan vary. Short squeezes can be seen
as events associated with large values of i
t
, which will invariably
exhibit price spikes (rallies followed by a steep drop).
The cost of shorting: buy-ins and efective dividend yield
Option market-makers need to hedge by trading the underlying
stock, both on the long and short side, with frequent adjustments.
However, securities that become hard to borrow are subject to
buy-ins as the rm needs to deliver shares according to the pres-
ently existing settlement rules. From a market- makers viewpoint,
a hard-to-borrow stock is essentially a security that presents an
increased likelihood of buy-ins.
Te prot or loss for a market-maker is aected by whether and
when their short stock is bought in and at what price. Generally,
this information is not known until the end of the trading day. To
model the economic eect of buy-ins, we assume that the traders
prot and loss from a short position of one share over a period (t,
t + dt) is:
P & L dS
t
yS
t
S
t
odW
t
+ i
t
ydt ( )
where Prob{ = 0} = 1 i
t
dt + o(dt) and Prob{ = 1} = i
t
dt +
o(dt). Tus, we assume that the trader who is short the stock does
not benet from the downward jump in equation (1) because they
are no longer short by the time the buy-in is completed. Te idea
is that the short trader takes an economic loss post-jump due to
the fact that their position was closed at the buy-in price.
Suppose then, hypothetically, that the trader was presented
with the possibility of renting the stock for the period (t, t + dt)
so that they can remain short and be guaranteed not to be bought
in. Te corresponding prot and loss would now include the neg-
ative of the downward jump, that is, yS
t
if the jump happened
right after time t. Since jumps and buy-ins occur with frequency
i
t
, the expected economic gain is i
t
yS
t
. It follows that the fair
value of the proposed rent is i
t
y per dollar of equity shorted. In
other words, i
t
y can be viewed as the cost-of-carry for borrowing
the stock.
Hence, we can interpret i
t
y as a convenience yield associated
with owning the stock when the buy-in rate is i
t
. Tis conven-
ience yield is monetised by holders of long positions lending
their stock out for one day at a time and charging the fee associ-
ated with the observed buy-in rate. Te convenience yield or
rent is mathematically equivalent to a stochastic dividend yield
that is credited to long positions and debited from holders of
short positions who enter into lending agreements. For traders
who are short but do not enter into such agreements, it is
assumed that stochastic buy-ins prevent them from gaining
from downward jumps.
We can therefore introduce an arbitrage-free pricing measure
associated with the physical process (1)(2), in which the rent, or
stock-nancing, i
t
y, cancels the drift component of the model
and the expected return is equal to the cost of carry. Under this
measure, our model takes the form:
dS
t
S
t
odW
t
+ rdt ydN
i
t
t ( ) (3)
where r is the instantaneous interest rate. Te absence of the
drift term i
t
y in this last equation is due to the fact that, under
an arbitrage-free pricing measure, the discounted price process
is a martingale.
It follows from equation (3) that the stock price in the risk-neu-
tral world can be written as:
S
t
S
0
e
rt
M
t
1 ( )
dN

t
t ( )
0
t
(4)
where the third factor represents the eects of buy-ins, and:
M
t
: exp oW
t

o
2
t
2

is the classical lognormal martingale.

Te rst application of the model is forward pricing. Assuming
constant interest rates, we have:
Forward Price E S
T
{
E S
0
e
oW
T

o
2
T
2
+rT
1 y ( )
dN
i
t
t ( )
0
T
[

S
0
e
rT
E e
i
t
dt
0
T
[
i
t
dt
0
T
[

_
,

k
k!
1 y ( )
k
k
_

S
0
e
rT
E e
y i
t
dt
0
T
[

(5)
Tis gives a mathematical formula for the forward price in
terms of the buy-in rate and the constant y. Clearly, if there are no
jumps, the formula becomes classical. Otherwise, notice that the
avellaneda.indd 94 27/5/09 11:35:01
risk.net 95
dividend is positive and delivering stock into a forward contract
requires hedging with less than one unit of stock, renting it along
the way to arrive at one share at delivery. From equation (5), the
term structure of forward dividend yields (d
t
) associated with the
model is given by:
e
d
t
dt
0
T

E e
y i
t
dt
0
T
[

(6)
Option pricing for hard-to-borrow stocks
Put-call parity for European-style options states that:
C K,T ( ) P K,T ( ) = S 1 DT ( ) K 1 RT ( )
where P(K, T), C(K, T) represent respectively the fair values of a
put and a call with strike K and maturity T, S is the spot price and
R, D are respectively the simply discounted interest rate and divi-
dend rate. It is equivalent to:
C
pop
K,T ( ) P
pop
K,T ( ) = KRT DST
(7)
where P
pop
(K, T) = P(K, T) max(K S, 0) represents the pre-
mium-over-parity for the put, a similar notation applying to calls.
It is well known that put-call parity does not hold for hard-to-
borrow stocks if we enter the nominal rates and dividend rates in
equation (7). Te price of conversions in actual markets should
therefore reect this. A long put position is mathematically equiv-
alent to being long a call and short 100 shares of common stock,
but this will not hold if the stock is a hard-to-borrow stock. Te
reason is that shorting costs money and the arbitrage between
puts and calls on the same line, known as a conversion, cannot be
made unless there is stock available to short. Conversions that
look attractive, in the sense that:
C
pop
K,T ( ) P
pop
K,T ( ) < KRT DST (8)
may not result in a risk-free prot due to the fact that the crucial
stock hedge (short 100 shares) may be impossible to establish.
We quantify deviations from put-call parity by considering the
function:
d
imp
K,T ( )
C
pop
K,T ( ) P
pop
K,T ( ) KRT
ST
, 0 K
(9)
As a function of K, d
imp
(K, T) will be approximately at for low
strikes and will rise slightly for large values of K because puts
become more likely to be exercised. Te dividend yield for the
stock should correspond roughly to the level of d
imp
(K, T) for at-
the-money strikes. If we consider American-style options on divi-
dend-paying stocks or exchange-traded funds (for example, the
S&P 500), then the implied dividend curve will, in addition, be
lower for low strikes, reecting the fact that calls have an early-
exercise premium.
Te situation is quite dierent for hard-to-borrow stocks, as we
can see from gures 4 and 5. Two distinctions are important: (i)
the implied dividend curve d
imp
(K, T) for K - S is not equal to the
nominal dividend yield (which is zero, in the case of the stocks
that are displayed in the gures) instead, it has a positive value;
and (ii) the implied dividend curve d
imp
(K, T) also bends for low
values of the strike, suggesting that calls with low strikes should
have an early exercise premium.
Te rst feature a change in level in the implied dividend
curve has to do with the extra premium for being long puts in a
world where shorting stock is dicult or expensive. Since syn-
thetic puts cannot be manufactured by owning calls and shorting
stock, the nominal put-call parity does not hold. Instead, it is
replaced by a functional put-call parity, which expresses the rela-
tive value of puts and calls via an eective dividend rate. Indeed,
if we dene the at-the-money implied dividend yield D
*
(T) =
d
imp
(S, T), we obtain the new parity relation:
C
pop
K,T ( ) P
pop
K,T ( ) = KRT D
*
T ( )ST
According to our model, we have, from equation (9):
D
*
T ( )
1 e
d
t
dt
0
T
[
T

1 E e
y i
t
dt
0
T
[

1
]
1
1
1
T
(10)
which connects the implied dividend rate obtained from the
options markets to the buy-in rate process.
0.50
0.45
0.40
0.35
0.30
0.25
0.20
0.15
0.10
0.05
0
I
m
p
l
i
e
d

d
i
v
i
d
e
n
d

(
%
)
Strike ($)
0 5 10 15 20 25 30 35 40 45
Note: the trade date is January 10, 2008 and the expiry is January 17,
2009. The stock price is $5.81. The best fit constant dividend rate is
approximately 15%. Dendreon does not pay dividends
4 Implied dividend rates as a function of strike price for
options on Dendreon
0.14
0.12
0.10
0.08
0.06
0.04
0.02
0
I
m
p
l
i
e
d

d
i
v
i
d
e
n
d

(
%
)
Strike ($)
0 50 100 150 200 250 300
Note: the dates are as in figure 4 and the stock price is $80.30. The
best fit dividend rate (associated with at-the-money options) is 5.5%.
VMWare does not pay dividends
5 Implied dividend rates for VMWare
avellaneda.indd 95 27/5/09 11:35:02
96 Risk June 2009
CUTTING EDGE. MARKET RISK
Te option market predicts dierent borrowing rates over time
for any given stock, through variations in the interest rate quoted
by clearing rms, and by conversion-reversals quoted by option
market-makers. Te latter approach suggests dierent implied
dividends per option series, that is, it contains market expecta-
tions of the varying degree of diculty of borrowing a stock in
the future. We can use the model (1)(2) and equation (10) to
calculate a term structure of eective dividends (or, equivalently,
short rates) that could be calibrated to any given stock. To gener-
ate such a term structure, we simulate paths of i
t
, 0 < t < T
max
and
calculate the discount factors by Monte Carlo. Figure 6 shows a
declining term structure, which is typical of most stocks. Tis
decay represents the fact that stocks rarely remain hard to borrow
over extremely long time periods.
If we make the approximation that i
t
is independent of W
t
, in
the sense that:
dX
t
xdZ
t
+ o X X
t ( )
dt +
t
dt dN

t
t ( )
( )
the model becomes more tractable and we obtain semi-explicit
pricing formulas for European-style puts and calls as series expan-
sions by separation of variables. To see this, we dene the
weights:
H n,T ( ) Prob dN
i
t
t ( ) n
0
T
[

E e
i
t
dt
0
T
[
i
t
dt
0
T
[

_
,

n
n!

(11)
Denote by BSCall(s, t, k, r, d, o) the Black-Scholes value of a
call option for a stock with price s, time to maturity t, strike price
k, interest rate r, dividend yield d and volatility o. We then have:
C S, K,T ( ) H n,T ( ) BSCall S 1 y ( )
n
,T, K, r, 0,
( )
n0

(12)
with a similar formula holding for European-style puts.
Notice that equation (4) can be viewed as the risk-neutral
process for a stock that pays a discrete dividend yS
t
with fre-
quency i
t
. Terefore, calls will be exercisable if they are deep
enough in-the-money. A heuristic explanation is that a trader
long a call and short stock would suer repeated buy-ins costing
more than the synthetic put forfeited by exercising. Unfortu-
nately, pricing an American-style call using the full model (3)
entails a high-dimensional numerical calculation, because the
number of jumps until time t:
dN

t
t ( )
0
t

is not a Markov process unless i

t
is constant. In other words, the
state of the system depends on the current value of i
t
and not just
on the number of jumps that occurred previously. Te case i
t
=
constant is an exception; it corresponds to = 0, that is, to the
absence of coupling between the price process and the buy-in
rate. Te calculation of American-style option prices in this case
is classical (see, for instance, Amin, 1993). Figure 7 shows the
curve d
imp
(K, T) for American-style options using the model, con-
sistent with the observed graphs of Dendreon and VMW (gures
4 and 5).
Hard-to-borrowness in leveraged short ETFs
Here, we show how hard-to-borrowness can also be observed, in
some cases, from price data for leveraged long and short ETFs.
Since short ETFs maintain a short position in the underlying
security, we expect that the cost of borrowing the underlying
shares should be reected in the value of the fund. Tus, we
should be able to observe the borrowing costs, by comparing the
prices of the short-leveraged product with the underlying ETF or
with a long-leveraged product.
Let U
t
(2)
and U
t
(2)
denote respectively the prices of a double-long
ETF and a double-short ETF on the same underlying index, S
t
. It
follows from the denition of these products that:
dU
t

U
t

dS
t
S
t
r p
t
( )dt + rdt fdt, e 2, 2 { (13)
where r is the benchmark funding rate (Libor or Fed Funds), f is
8
9
10
11
12
13
14
15
16
T (years)
D
*
(
T
)

(
%
)

0 0.5 1.0 1.5 2.0
Note: D*(T) for
0
= 15, = 0.01, = 30, = 0.5
6 Term structure of effective dividend rates
0.18
0.16
0.14
0.12
0.10
0.08
0.06
0.04
0.02
0
I
m
p
l
i
e
d

d
i
v
i
d
e
n
d

(
%
)
Strike
50 60 70 80 90 100 110 120 130 140 150
Note: we assume that the stock price is $100, = 0.50, = 1.00,

0
= 50, T = 0.5yrs, = 0.03, r = 10%. The effective dividend rate is
d
imp
(100, T) = 14%. For low strikes, the drop in value is related to
the early exercise of calls, a feature unique to hard-to-borrow
stocks. For high strikes, the broad increase corresponds to the
classical early exercise property of in-the-money puts
7 Theoretical implied dividend yield d
imp
(K, T) generated
by the model
avellaneda.indd 96 27/5/09 11:35:03
risk.net 97
the expense ratio or management fee and:

t

t
if 0
0 if 0
(14)
Tus p
t
is the instantaneous (annualised) rent that is associated
with shorting the underlying stock. We can view p
t
as a proxy
for yi
t
, the expected shortfall for a short-seller subject to buy-in
risk, or the fair reduced rate associated with shorting the
underlying asset.
We obtain:
dU
t
2 ( )
U
t
2 ( )
+
dU
t
2 ( )
U
t
2 ( )
= 2 r
t
( ) f ( )dt
which implies that:

t
dt
dU
t
2 ( )
U
t
2 ( )

dU
t
2 ( )
U
t
2 ( )
2 f 2r ( )dt
2
(15)
Tis suggests that we can use daily data on leveraged ETFs to
estimate the cost of borrowing the underlying stock.
For the empirical analysis, we used dividend-adjusted closing
prices from the PowerShares Ultrashort Financial ETF (SKF) and
the PowerShares Ultralong Financial ETF (UYG). Te underly-
ing ETF is the Barclays Dow Jones Financial Index ETF. Using
historical data, we calculated the right-hand side of equation (15),
which we interpret as corresponding to daily sampling, with dt =
1/252, r = 3-month Libor and f = 0.95%, the expense ratio of
SKF and UYG advertised by Powershares. Te results of the sim-
ulation are seen in gure 8.
We see that p
t
, the cost of borrowing, varies in time and can
change quite dramatically. In gure 8, we consider a 10-day mov-
ing average of p
t
to smooth out the eect of volatility and end-of-
day marks. Te data shows that increases in borrowing costs, as
implied from the leveraged ETFs, began in late summer 2008
and intensied in mid-September, when Lehman Brothers col-
lapsed and the US Securities and Exchange Commission (SEC)
ban on shorting 800 nancial stocks was implemented (the latter
occurred on September 19, 2008). Notice that the implied bor-
rowing costs for nancial stocks remain elevated subsequently,
despite the fact that the SEC ban on shorting was removed in
mid-October. Tis calculation may be interpreted as exhibiting
the variations of i
t
(or yi
t
) for a basket of nancial stocks. For
instance, if we assume that the elasticity remains constant (for
example, at 2%), the buy-in rate will range from a low number
(for example, i = 1, or one buy-in a year) to 50 or 80, correspond-
ing to several buy-ins a week.
Conclusion
In the past, attempts have been made to understand option pric-
ing for hard-to-borrow stocks using models that do not take
into account price dynamics. Tis approach leads to a view of
put-call parity that is at odds with the functional equilibrium
(steady state) evidenced in the options markets, in which put
and call prices are stable and yet naive put-call parity does not
hold. Te point of this article has been to show how dynamics
and pricing are intertwined. Te notion of eective dividend is
the principal consequence of our model, which also obtains a
term structure of dividend yields. Reasonable parametric choices
lead to a term structure that is concave down, a shape frequently
seen in real option markets. Te model also reproduces the
(American-style) early exercise features, including early exercise
of calls, which cannot happen for non-dividend-paying easy-to-
borrow stocks. N
Marco Avellaneda is professor of mathematics at New York University.
Mike Lipkin is adjunct professor of finance at Columbia University and
managing member of Katama Trading. They would like to thank the
referees for many helpful and insightful comments, Sacha Stanton of
Modus Incorporated for assistance with options data and Stanley Zhang
for exciting discussions on leveraged exchange-traded funds. Email:
marco.avellaneda@gmail.com, mike.katama@gmail.com
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References
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Note: the thin line corresponds to the daily values of the cost of
borrowing parameter
t
, in percentage points, estimated from
equation (16). The thick line is a 10-day moving average. Hard-to-
borrowness exceeds 100% in SeptemberOctober 2008 and remains
elevated until March 2009
8 The cost of borrowing the Barclays Dow Jones
Financial Index
avellaneda.indd 97 27/5/09 11:35:04