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Stochastic arbitrage return and its implication for option pricing

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  • Fedotov, Sergei
  • Panayides, Stephanos

Abstract

The purpose of this work is to explore the role that random arbitrage opportunities play in pricing financial derivatives. We use a non-equilibrium model to set up a stochastic portfolio, and for the random arbitrage return, we choose a stationary ergodic random process rapidly varying in time. We exploit the fact that option price and random arbitrage returns change on different time scales which allows us to develop an asymptotic pricing theory involving the central limit theorem for random processes. We restrict ourselves to finding pricing bands for options rather than exact prices. The resulting pricing bands are shown to be independent of the detailed statistical characteristics of the arbitrage return. We find that the volatility “smile” can also be explained in terms of random arbitrage opportunities.

Suggested Citation

  • Fedotov, Sergei & Panayides, Stephanos, 2005. "Stochastic arbitrage return and its implication for option pricing," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 345(1), pages 207-217.
    • Handle: RePEc:eee:phsmap:v:345:y:2005:i:1:p:207-217
    DOI: 10.1016/j.physa.2004.07.028
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    References listed on IDEAS

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    1. Lisa Borland, 2002. "A theory of non-Gaussian option pricing," Quantitative Finance, Taylor & Francis Journals, vol. 2(6), pages 415-431.
    2. L. Borland & J. P. Bouchaud, 2004. "A Non-Gaussian Option Pricing Model with Skew," Papers cond-mat/0403022, arXiv.org, revised Mar 2004.
    3. Martin Schweizer, 1995. "Variance-Optimal Hedging in Discrete Time," Mathematics of Operations Research, INFORMS, vol. 20(1), pages 1-32, February.
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    5. Erik Aurell & Sergei I. Simdyankin, 1998. "Pricing Risky Options Simply," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 1(01), pages 1-23.
    6. Lisa Borland & Jean-Philippe Bouchaud, 2004. "A non-Gaussian option pricing model with skew," Quantitative Finance, Taylor & Francis Journals, vol. 4(5), pages 499-514.
    7. Matthias Otto, 2000. "Towards Non-Equilibrium Option Pricing Theory," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 3(03), pages 565-565.
    8. Alan L. Lewis, 2000. "Option Valuation under Stochastic Volatility," Option Valuation under Stochastic Volatility, Finance Press, number ovsv, December.
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    Citations

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    Cited by:

    1. Contreras, Mauricio & Montalva, Rodrigo & Pellicer, Rely & Villena, Marcelo, 2010. "Dynamic option pricing with endogenous stochastic arbitrage," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 389(17), pages 3552-3564.
    2. Haven, Emmanuel, 2008. "Elementary Quantum Mechanical Principles and Social Science: Is There a Connection?," Journal for Economic Forecasting, Institute for Economic Forecasting, vol. 5(1), pages 41-58, March.
    3. Mauricio Contreras G, 2020. "Endogenous Stochastic Arbitrage Bubbles and the Black--Scholes model," Papers 2009.09329, arXiv.org.
    4. Mauricio Contreras & Rely Pellicer & Daniel Santiagos & Marcelo Villena, 2015. "Calibration and simulation of arbitrage effects in a non-equilibrium quantum Black-Scholes model by using semiclassical methods," Papers 1512.05377, arXiv.org.
    5. Emmanuel Haven, 2008. "Private Information and the ‘Information Function’: A Survey of Possible Uses," Theory and Decision, Springer, vol. 64(2), pages 193-228, March.
    6. Contreras, M. & Echeverría, J. & Peña, J.P. & Villena, M., 2020. "Resonance phenomena in option pricing with arbitrage," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 540(C).
    7. Stephanos Panayides, 2005. "Arbitrage Opportunities and their Implications to Derivative Hedging," Papers cond-mat/0502029, arXiv.org, revised Jun 2005.
    8. Contreras, Mauricio & Pellicer, Rely & Villena, Marcelo & Ruiz, Aaron, 2010. "A quantum model of option pricing: When Black–Scholes meets Schrödinger and its semi-classical limit," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 389(23), pages 5447-5459.
    9. Contreras G., Mauricio, 2021. "Endogenous stochastic arbitrage bubbles and the Black–Scholes model," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 583(C).
    10. Panayides, Stephanos, 2006. "Arbitrage opportunities and their implications to derivative hedging," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 361(1), pages 289-296.

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