Arbitrage Opportunities in Misspecified Stochastic volatility Models
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.
Keywords
Cite
@article{arxiv.1002.5041,
title = {Arbitrage Opportunities in Misspecified Stochastic volatility Models},
author = {Rudra P. Jena and Peter Tankov},
journal= {arXiv preprint arXiv:1002.5041},
year = {2011}
}
Comments
Several typos in section 5 have been corrected in this new version (with thanks to Amy Y. Zhou from MIT)