Derivative Arbitrage Strategies in Cryptocurrency Markets

Abstract

Cryptocurrency derivatives markets exhibit numerous pricing inconsistencies. This paper examines an approach that leverages price divergences between inverse vanilla options and binary options from prediction markets. It posits that, under certain conditions, the combination of these two instruments enables the construction of a portfolio with a negative-free payoff at expiration. To validate this hypothesis, we derive the unified condition required for constructing such a portfolio and establish the theoretical framework for its formation. Subsequently, to evaluate the practical relevance of this arbitrage, we define a trading strategy based on this framework and test it on Bitcoin and Ether markets. The results indicate that, although arbitrage opportunities are infrequent, the strategy remains highly profitable. Furthermore, none of the trades executed yield a negative return at expiration, thereby validating our initial assumption. Overall, this paper contributes to the study of arbitrage in cryptocurrency markets. On the one hand, it proposes the theoretical foundation for a novel vanilla-binary option arbitrage strategy. On the other, it provides a benchmark for pricing prediction market binary options.

Keywords: Cryptocurrencies, Arbitrage, Inverse options, Binary options, Pricing

JEL Classification: G11, G12, G15