Limits to Arbitrage and the Skewness Risk Premium in Options Markets

57 Pages Posted: 19 Nov 2011 Last revised: 23 Jan 2012

See all articles by Thomas Ruf

Thomas Ruf

University of New South Wales (UNSW)

Date Written: January 20, 2012

Abstract

Option prices, particularly those of out-of-the-money equity index puts, are difficult to justify in a no-arbitrage framework. This paper shows how limits to arbitrage affect the relative pricing of out-of-the-money put vs. call options (option-implied skewness). Decomposing the price of skewness into ex-post realized skewness and a skewness risk premium in commodity futures options markets, I find that the skewness risk premium increases, but realized skewness remains unchanged, when i) arbitrageurs hold larger net long positions in options, and ii) long positions in the underlying asset are concentrated among fewer traders. In addition, the first effect is stronger when arbitrageurs are more financially constrained. Trading strategies designed to theoretically exploit these limits yield up to 2 percent per month after risk-adjustment. The results provide solid support for the existence of a limits to arbitrage effect on option prices as well as option returns.

Keywords: Commodity Futures, Option-implied Skewness, Limits to Arbitrage

JEL Classification: G13

Suggested Citation

Ruf, Thomas, Limits to Arbitrage and the Skewness Risk Premium in Options Markets (January 20, 2012). Available at SSRN: https://ssrn.com/abstract=1961869 or http://dx.doi.org/10.2139/ssrn.1961869

Thomas Ruf (Contact Author)

University of New South Wales (UNSW) ( email )

Kensington
High St
Sydney, NSW 2052
Australia

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