Limits of Arbitrage and Primary Risk Taking in Derivative Securities

58 Pages Posted: 26 Feb 2021 Last revised: 26 Apr 2021

See all articles by Meng Tian

Meng Tian

City University of New York, CUNY Baruch College - Zicklin School of Business

Liuren Wu

City University of New York, CUNY Baruch College - Zicklin School of Business

Date Written: February 4, 2021

Abstract

Classic option pricing theory values a derivative contract via dynamic replication, and views the derivative as redundant relative to the replicating portfolio. In practice, while dynamic replication proves highly effective in drastically reducing the risk in derivative investments, the remaining risk can still be large and significant due to practical limits of arbitrage. Because of these limits, derivative securities can play primary roles in risk allocation and investors can demand compensation for taking these primary risks. This paper documents the effectiveness of delta hedging on U.S. stock options under practical situations, examines the cross-sectional and intertemporal variation of investment returns from writing options on different stocks, and attributes the return variation to variations in primary risk exposures in the delta-hedged option investments.

Keywords: Dynamic hedging; Option investment returns; Limits of arbitrage; Trading cost; Stochastic volatility; Jumps

JEL Classification: C13; C51; G12; G13

Suggested Citation

Tian, Meng and Wu, Liuren, Limits of Arbitrage and Primary Risk Taking in Derivative Securities (February 4, 2021). Available at SSRN: https://ssrn.com/abstract=3779350 or http://dx.doi.org/10.2139/ssrn.3779350

Meng Tian

City University of New York, CUNY Baruch College - Zicklin School of Business ( email )

One Bernard Baruch Way
New York, NY 10010
United States

Liuren Wu (Contact Author)

City University of New York, CUNY Baruch College - Zicklin School of Business ( email )

One Bernard Baruch Way
Box B10-247
New York, NY 10010
United States
646-312-3509 (Phone)
646-312-3451 (Fax)

HOME PAGE: http://faculty.baruch.cuny.edu/lwu/

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