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Arbitrage Opportunities in Misspecified Stochastic volatility Models

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  • Rudra P. Jena
  • Peter Tankov

Abstract

There is vast empirical evidence that given a set of assumptions on the real-world dynamics of an asset, the European options on this asset are not efficiently priced in options markets, giving rise to arbitrage opportunities. We study these opportunities in a generic stochastic volatility model and exhibit the strategies which maximize the arbitrage profit. In the case when the misspecified dynamics is a classical Black-Scholes one, we give a new interpretation of the classical butterfly and risk reversal contracts in terms of their (near) optimality for arbitrage strategies. Our results are illustrated by a numerical example including transaction costs.

Suggested Citation

  • Rudra P. Jena & Peter Tankov, 2010. "Arbitrage Opportunities in Misspecified Stochastic volatility Models," Papers 1002.5041, arXiv.org, revised Sep 2011.
    • Handle: RePEc:arx:papers:1002.5041
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    File URL: http://arxiv.org/pdf/1002.5041
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    Cited by:

    1. Sofiene El Aoud & Frédéric Abergel, 2015. "A stochastic control approach for options market making," Post-Print hal-01061852, HAL.

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