A Theory of Inefficient Quotes: Empirical Evidence in Options Markets

34 Pages Posted: 5 Mar 2007

See all articles by Iñaki Rodríguez-Longarela

Iñaki Rodríguez-Longarela

Stockholm University - Stockholm Business School; UiT-The Arctic University of Norway - School of Business and Economics

Silvia Mayoral

Universidad Carlos III de Madrid

Date Written: March 2007

Abstract

In an arbitrage-free economy with non-zero bid-ask spreads, the presence of payoffs, whose price is lower than the price of another payoff where the former dominates the latter, can not be discarded in general. However, their presence is a true market anomaly when the former price corresponds to trivial portfolios which involve buying or selling one unit of the basis assets. We refer to these prices as inefficient quotes and we characterize their absence by imposing certain conditions on the set of admissible Stochastic Discount Factors. A measure of overall quote inefficiency is also introduced. We report, in an empirical study, evidence that indicates that in options markets, both the frequency and the magnitude of these inefficiencies, are substantial. Also, we find puzzling patterns in the behavior of these inefficiencies.

Keywords: Inefficienct Quotes, Bid-Ask Spread, Law of One Price, Index Options

JEL Classification: C61, C63, D40, G10

Suggested Citation

Rodríguez Longarela, Iñaki and Mayoral, Silvia, A Theory of Inefficient Quotes: Empirical Evidence in Options Markets (March 2007). EFA 2007 Ljubljana Meetings Paper. Available at SSRN: https://ssrn.com/abstract=967679 or http://dx.doi.org/10.2139/ssrn.967679

Iñaki Rodríguez Longarela (Contact Author)

Stockholm University - Stockholm Business School ( email )

Stockholm
Sweden

UiT-The Arctic University of Norway - School of Business and Economics ( email )

Tromsø, 9037
Norway

Silvia Mayoral

Universidad Carlos III de Madrid ( email )

C/ Madrid 124,
Getafe, Madrid 28093
Spain

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