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Limits of Arbitrage and Primary Risk-Taking in Derivative Securities

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  • Meng Tian
  • Liuren Wu
  • Zhiguo He

Abstract

Classic option pricing theory values a derivative contract via dynamic delta hedging and treating the contract as redundant relative to the underlying security. Dynamic delta hedging proves highly effective in practice, but the remaining risk is still large because of the practical limits of arbitrage. Derivatives can play primary roles in risk allocation. This paper quantifies the percentage variance reduction of delta hedging on U.S. stock options, proposes a top-down return attribution framework to identify the remaining risk sources of the delta-hedged option investment, and constructs a statistical return factor model to explain the variations of the delta-hedged option returns. (JEL C13, C51, G12, G13)

Suggested Citation

  • Meng Tian & Liuren Wu & Zhiguo He, 2023. "Limits of Arbitrage and Primary Risk-Taking in Derivative Securities," The Review of Asset Pricing Studies, Society for Financial Studies, vol. 13(3), pages 405-439.
    • Handle: RePEc:oup:rasset:v:13:y:2023:i:3:p:405-439.
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    File URL: http://hdl.handle.net/10.1093/rapstu/raad003
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    JEL classification:

    • C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General
    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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