Arbitrage Opportunities in Misspecified Stochastic volatility Models

Details Arbitrage Opportunities in Misspecified Stochastic volatility Models Arbitrage Opportunities in Misspecified Stochastic volatility Models

2010-02-26

arxiv.org/abs/1002.5041v3

SIAM J. Finan. Math. 2, pp. 317-341 (2011)

Economy

Quantitative Finance

Pricing of Securities

Several typos in section 5 have been corrected in this new version (with thanks to Amy Y. Zhou from MIT)

Scientific paper

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.

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