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Arbitrage With Options

Arbitrage With Options

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Published by lycancapital

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Published by: lycancapital on Aug 23, 2011
Copyright:Attribution Non-commercial


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Dallas BrozikProfessor of FinanceMarshall UniversityDivision of Finance and EconomicsHuntington, West Virginia 2575-2320(304) 696-2663(304) 696-3662FAXbrozik@marshall.edu
Option pricing theory encompasses two distinct contracts, thecall option and the put option. Existing option pricing modelstreat the two contracts as opposites that use the same relevantpricing factors in similar manners. These models also assumethat the option market is efficient and unbiased. This paper examines the option market and finds it to be inefficient andbiased in the pricing of call and put options. This difference inpricing behavior gives rise to profitable arbitrage opportunitiesby combining call and put options with an underlying stock.
Option pricing is one of the most researched areas of finance. Several differentoption pricing models have been developed, each with its own strengths and weaknesses.One common characteristic of these models is that call options and put options are treatedas opposites by the pricing model. While this might be intuitively appealing, there is no
a priori 
reason to believe that market participants price these contracts in an identical butopposite manner. Option prices reflect the behavior of the market participants, and if thereis a difference between the behavior of the buyers/sellers of call options and thebuyers/sellers of put options, then any option pricing model will need to reflect thisdifference in the pricing of the different contracts.Implicit to all symmetric pricing models is the assumption that the market in whichthe contracts trade is efficient. It would be possible to have symmetric pricing in aninefficient market if the mispricing incidents were randomly distributed, and such “noise”would make it difficult to test any theoretical pricing model. If the market were biased and
showed evidence of systematic mispricing, symmetric pricing models would not bepossible.
The Black-Scholes [1973] option pricing model provided a basis for a better understanding of the pricing of options and contingent claims securities. When applied tostock options, the model is able to explain much about how option prices are set, but therehave been numerous studies that have found discrepancies between actual and predictedprices. Many researchers have attempted to explain these anomalies by changing certaincharacteristics of the model, like the interest rate specification process, and other researchers have focused on market factors like dividend payments to the underlying stock(for example, Black [1975], Black and Scholes [1973], Geske and Roll [1984], Gultekin,Rogalski, and Tinic [1982], MacBeth and Merville [1989], and Rubinstein [1985]). It shouldbe noted that all of these researchers restricted their data to call options. Even the reviewof various option pricing models conducted by Bakshi, Cao, and Chen [1997] used only calloption data. All of this research does have a common, though seldom expressed, characteristic.In all these models the pricing of the call option and the pricing of the put option are seento be identical, though in opposite directions. The profit and loss diagrams for calls andputs are mirror images at maturity, so it is apparently assumed that while the option isactive the same pricing mechanism is at work. This assumption is further supported by theacceptance of the put/call parity theory. Even though tests of the put/call parity theoryshow anomalies (Brenner and Galai [1986], Frankfurter and Leung [1991], Klemkosky and

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