Option pricing under short-lived arbitrage: theory and tests

Models in financial economics derived from no-arbitrage assumptions have found great favour among theoreticians and practitioners. We develop a model of option prices where arbitrage is short lived. The arbitrage process is Ornstein–Uhlenbeck with zero mean and rapid adjustment of deviations. We find that arbitrage correlated with the underlying can have sizeable impact on option prices. We use data from five large capitalization firms to test implications of the model. Consistent with the existence of arbitrage, we find that idiosyncratic factors significantly effect arbitrage model parameters.