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Options Arbitrage in Imperfect Markets
Author(s) -
FIGLEWSKI STEPHEN
Publication year - 1989
Publication title -
the journal of finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 18.151
H-Index - 299
eISSN - 1540-6261
pISSN - 0022-1082
DOI - 10.1111/j.1540-6261.1989.tb02654.x
Subject(s) - arbitrage , economics , index arbitrage , imperfect , valuation (finance) , volatility (finance) , expiration date , convertible arbitrage , exotic option , risk arbitrage , financial economics , econometrics , valuation of options , arbitrage pricing theory , capital asset pricing model , finance , linguistics , philosophy , chemistry , food science
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, transactions costs, indivisibilities, and rebalancing only at discrete intervals. We find 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.