Pricing American options when there is short-lived arbitrage

Jimmy E. Hilliard and Jitka Hilliard

International Journal of Financial Markets and Derivatives, 2015, vol. 4, issue 1, 43-53

Abstract: Models in financial economics derived from no-arbitrage assumptions are standard fare among theoreticians and practitioners. However, several authors have investigated the impact of short lived arbitrage on European options using models borrowed from disequilibria in physics. In this paper, we extend that research by assessing the impact of arbitrage on American options. We use an Ornstein-Uhlenbeck Bridge as a model for the arbitrage process and calculate American option prices using a bivariate lattice with density matched probabilities. We find that arbitrage correlated with the underlying has an economically meaningful sizeable impact on option prices. Short lived arbitrage has essentially virtually no economic impact on option prices when the arbitrage is uncorrelated with underlying asset returns.

Keywords: Ornstein-Uhlenbeck Bridge; American options; option pricing; short-lived arbitrage; bivariate lattice; density matched probabilities. (search for similar items in EconPapers)
Date: 2015
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