Price dispersion and vanilla options in a financial market game

Toraubally, W. ORCID: 0000-0002-2684-7360, 2022. Price dispersion and vanilla options in a financial market game. Finance Research Letters, 50: 103305. ISSN 1544-6123

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We construct a game-theoretic model characterised by perfect information, no transaction costs, in which agents can borrow at the risk-free interest rate and engage in short sell- ing. Traders can freely and instantaneously eliminate any unexploited profit opportunities through pure arbitrage just as the efficient market hypothesis postulates they should. Yet, in this work we put forth, in a frictionless framework, a counterexample in which the Law of One Price fails in the underlying assets markets at equilibrium. At a theoretical level, this leads both the Binomial Option Pricing Model (BOPM) and in the limit, the Black–Scholes– Merton Model (BSMM), to misprice the vanilla options written on these assets. This com- pelling result is pregnant with far-reaching ramifications: (i) theoretically, it establishes that no-arbitrage, while necessary, is not sufficient for any of the BOPM and BSMM to yield con- sistent results; (ii) practically, it crystallises the need for practitioners to rely on additional, more data-adaptive, methods of option pricing.

Item Type: Journal article
Publication Title: Finance Research Letters
Creators: Toraubally, W.
Publisher: Elsevier
Date: December 2022
Volume: 50
ISSN: 1544-6123
Divisions: Schools > Nottingham Business School
Record created by: Laura Ward
Date Added: 07 Sep 2022 09:10
Last Modified: 06 Sep 2023 03:00

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