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Pricing American options when there is short-lived arbitrage

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  • Jimmy E. Hilliard
  • Jitka Hilliard

Abstract

Models in financial economics derived from no-arbitrage assumptions are standard fare among theoreticians and practitioners. However, several authors have investigated the impact of short lived arbitrage on European options using models borrowed from disequilibria in physics. In this paper, we extend that research by assessing the impact of arbitrage on American options. We use an Ornstein-Uhlenbeck Bridge as a model for the arbitrage process and calculate American option prices using a bivariate lattice with density matched probabilities. We find that arbitrage correlated with the underlying has an economically meaningful sizeable impact on option prices. Short lived arbitrage has essentially virtually no economic impact on option prices when the arbitrage is uncorrelated with underlying asset returns.

Suggested Citation

  • Jimmy E. Hilliard & Jitka Hilliard, 2015. "Pricing American options when there is short-lived arbitrage," International Journal of Financial Markets and Derivatives, Inderscience Enterprises Ltd, vol. 4(1), pages 43-53.
    • Handle: RePEc:ids:ijfmkd:v:4:y:2015:i:1:p:43-53
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    Cited by:

    1. Abel Azze & Bernardo D'Auria & Eduardo Garc'ia-Portugu'es, 2022. "Optimal stopping of Gauss-Markov bridges," Papers 2211.05835, arXiv.org, revised Dec 2023.

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