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Options Arbitrage in Imperfect Markets

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Author Info
 Figlewski, Stephen
Abstract

Option valuation models are based on an arbitrage strategy--hedging the option against the underlying asset and rebalancing continuously until expiration--that is only possible in a frictionless market. This paper simulates the impact of market imperfections and other problems with the "standard" arbitrage trade, including uncertain volatility, transaction costs, indivisibilities, and rebalancing only at discrete intervals. The author finds that, in an actual market such as that for stock index options, the standard arbitrage is exposed to such large risk and transactions costs that it can only establish very wide bounds on equilibrium options prices. This has important implications for price determination in options markets, as well as for testing of valuation models. Copyright 1989 by American Finance Association.

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Publisher Info
Article provided by American Finance Association in its journal Journal of Finance.

Volume (Year): 44 (1989)
Issue (Month): 5 (December)
Pages: 1289-1311
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Handle: RePEc:bla:jfinan:v:44:y:1989:i:5:p:1289-1311

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  1. Han, Bin, 2004. "Limits of Arbitrage, Sentiment and Pricing Kernal: Evidences from Index Options," Working Paper Series 2004-2, Ohio State University, Charles A. Dice Center for Research in Financial Economics. [Downloadable!]
  2. Robert F. Engle & Joshua V. Rosenberg, 1995. "GARCH Gamma," NBER Working Papers 5128, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  3. N. Chidambaran, 2007. "Density estimation through quasi-analytic Monte-Carlo simulation: Options arbitrage with transactions costs," Review of Quantitative Finance and Accounting, Springer, vol. 28(1), pages 101-122, January. [Downloadable!] (restricted)
  4. Patrick Dennis & Stewart Mayhew, 2009. "Microstructural biases in empirical tests of option pricing models," Review of Derivatives Research, Springer, vol. 12(3), pages 169-191, October. [Downloadable!] (restricted)
  5. Ahoniemi, Katja & Lanne, Markku, 2007. "Joint Modeling of Call and Put Implied Volatility," MPRA Paper 6318, University Library of Munich, Germany. [Downloadable!]
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  6. Nicolae Garleanu & Lasse Heje Pedersen & Allen M. Poteshman, 2005. "Demand-Based Option Pricing," NBER Working Papers 11843, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  7. George M. Constantinides & Stylianos Perrakis, 2002. "Stochastic Dominance Bounds on Derivative Prices in a Multiperiod Economy with Proportional Transaction Costs," NBER Working Papers 8867, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  8. Flavio Angelini & Stefano Herzel, 2007. "Explicit formulas for the minimal variance hedging strategy in a martingale case," Quaderni del Dipartimento di Economia, Finanza e Statistica 35/2007, Università di Perugia, Dipartimento Economia, Finanza e Statistica. [Downloadable!]
  9. David Bakstein & Sam Howison, 2002. "A Risk-Neutral Parametric Liquidity Model for Derivatives," OFRC Working Papers Series 2002mf02, Oxford Financial Research Centre. [Downloadable!]
  10. Rama CONT, 1998. "Beyond implied volatility: extracting information from option prices," Finance 9804002, EconWPA. [Downloadable!]
  11. Cornelis Los, 2004. "Measuring the Degree of Efficiency of Financial Market," Finance 0411003, EconWPA. [Downloadable!]
  12. Peter Carr & Liuren Wu, 2004. "Static Hedging of Standard Options," Finance 0409016, EconWPA. [Downloadable!]
  13. Elyès Jouini & Hédi Kallal, 1999. "Efficient Trading Strategies in the Presence of Market Frictions," New York University, Leonard N. Stern School Finance Department Working Paper Seires 99-035, New York University, Leonard N. Stern School of Business-. [Downloadable!]
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