Derivatives Valuation Based on Arbitrage: The Trade Is Crucial

Abstract

Derivatives valuation has strong theoretical support because models are derived from the principle that arbitrage between the derivative and its underlying will eliminate riskless profits and drive the market price to the model value. "No-arbitrage" is invoked routinely whenever a new pricing model is developed. But real world market prices are determined by trades, not by theories. In this talk, I discuss how different the arbitrage trade is for different markets and different models and I review articles from the literature that illustrate how limits to the arbitrage trade have affected the way derivatives theory gets into prices in practice.

Keywords: Limits to Arbitrage, Theory vs Practice, Derivatives Valuation, Options, Futures Pricing

JEL Classification: G13, G14, G12