Stern School of Business, New York University. The author would like to thank John Merrick, Roni Michaely, William Silber, and the referee, Mark Rubinstein, for helpful comments.
Options Arbitrage in Imperfect Markets
Article first published online: 30 APR 2012
1989 The American Finance Association
The Journal of Finance
Volume 44, Issue 5, pages 1289–1311, December 1989
How to Cite
FIGLEWSKI, S. (1989), Options Arbitrage in Imperfect Markets. The Journal of Finance, 44: 1289–1311. doi: 10.1111/j.1540-6261.1989.tb02654.x
- Issue published online: 30 APR 2012
- Article first published online: 30 APR 2012
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.