Topic
Options arbitrage
About: Options arbitrage is a research topic. Over the lifetime, 10 publications have been published within this topic receiving 315 citations.
Papers
TL;DR: In this paper, the authors show 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.
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, 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. AMONG ALL THEORIES IN finance, the Black-Scholes option pricing model has perhaps had the biggest impact on the real world of securities trading. Virtually all market participants are aware of the model and use it in their decision making. Academics regularly test the model's valuation on actual market prices and typically conclude that, while not every feature is accounted for, the model works very well in explaining observed option prices.' Most option valuation models are based on an arbitrage argument. Under the assumptions of the model, the option can be combined with the underlying asset into a hedged position that is riskless for local changes in the asset's price and in time and must therefore earn the riskless interest rate. This leads to a theoretical value for the option such that profitable arbitrage is ruled out. However, while virtually all options traders are aware of option pricing theory and most use it in some way, the arbitrage mechanism assumed in deriving the theory cannot work in a real options market in the same way that it does in a frictionless market. The disparity between options arbitrage in theory and in practice is the subject of this paper. Some of the important assumptions made in deriving the Black-Scholes model are the following. * The price of the underlying asset follows a logarithmic diffusion process that
296 citations
TL;DR: In this article, the authors find strong evidence in stock options transactions data from periods 10 years apart that the market prices these risks and there is a significant price effect associated with convexity, that becomes larger immediately following a period of larger stock price movements.
Abstract: Option valuation formulas typically assume all risk can be eliminated in a continuously rebalanced hedge, but convexity of the option pricing function and time decay cause risk in real world hedges. We find strong evidence in stock options transactions data from periods 10 years apart that the market prices these risks. There is a significant price effect associated with convexity, that becomes larger immediately following a period of larger stock price movements. Although time decay is highly correlated with convexity, a multiple regression including both factors shows it to have a significant independent effect. The results from the two sample periods are highly consistent, as are pre- and post-Crash results from the year 1987.
10 citations
Book•
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1 Jan 1994
TL;DR: Basics of options as discussed by the authors - Basic Pricing of Options - Advanced Pricing of options - Basic Issues in Volatility Estimation - Advanced Issues in VOLUME 7, 2019 - Volatility Trading Strategies - Options Arbitrage - Trading Options Between Markets - Basic Hedging with Options - Portfolio Applications of Options Products - OTC Interest Rate Options - Exotic Options - Risk Management of Options Books - Organisation of Option Markets - Accounting, Regulations and Tax Issues in Options
Abstract: Basics of Options - Basic Pricing of Options - Advanced Pricing of Options - Basic Issues in Volatility Estimation - Advanced Issues in Volatility Estimation - Directional Trading Strategies - Volatility Trading Strategies - Options Arbitrage - Trading Options Between Markets - Basic Hedging with Options - Portfolio Applications of Options Products - OTC Interest Rate Options - Exotic Options - Risk Management of Options Books - Organisation of Option Markets - Accounting, Regulations and Tax Issues in Options
5 citations
TL;DR: In this paper, the authors use a quasi-analytic procedure that combines the computational efficiency of analytical solutions with the flexibility of simulations to estimate the distribution of returns of the arbitrage strategy by mapping simulated returns percentiles and the input parameter set.
Abstract: Discretely rebalanced options arbitrage strategies in the presence of transaction costs have path dependent returns that are difficult to model analytically. I instead use a quasi-analytic procedure that combines the computational efficiency of analytical solutions with the flexibility of simulations. The central feature is the estimation of the distribution of returns of the arbitrage strategy by mapping simulated returns percentiles and the input parameter set. Using the estimated density, I evaluate the tradeoff between transaction costs and risk exposure under generalized transaction costs structures that includes bid-ask spread and brokerage commission. I show that the optimal strategy depends on transaction costs, volatility, and option moneyness. Strategies such as rebalancing when the hedge ratio changes by 0.25, balances transaction costs and risk exposure, and can be optimal.
2 citations
TL;DR: In this article, the authors investigated the arbitrage profitability of American index options and found evidence of profitable arbitrage opportunities, while the frequency of observations violating no-arbitrage bounds and the magnitude of arbitrage profits decrease with the level of transaction costs.
Abstract: Previous studies have examined the profitability of European index options arbitrage. This paper adds to the literature by investigating the arbitrage profitability of American index options—the Nikkei 225 index futures options traded on the Singapore Stock Exchange (SGX). Using the real-time bid–ask prices, we find evidence of profitable arbitrage opportunities, while the frequency of observations violating no-arbitrage bounds and the magnitude of arbitrage profits decrease with the level of transaction costs. Our results have implications for the analysis of American options market efficiency. Failure to use bid–ask prices may lead to biased conclusions.
1 citations
Related Topics (5)
Performance Metrics
| Year | Papers |
|---|---|
| 2021 | 1 |
| 2010 | 2 |
| 2008 | 1 |
| 2006 | 1 |
| 2005 | 1 |
| 2004 | 1 |