Abstract:
Discrepancies between theoretical option pricing models and actual market
prices create arbitrage opportunities in financial markets. Despite being
widely used in option pricing, the famous Black-Scholes model estimates op-
tion values based on the strict assumption of no arbitrage. In addition, its as-
sumptions of constant volatility and log-normal asset price distribution may
not fully capture real-world market dynamics, resulting in mispricing and
potential arbitrage opportunities. The Information-based model is adopted as
an alternative to address this, allowing for stochastic volatility, non-specific
asset price distributions, and variable transaction costs. This study extends
the IBM by developing a pricing equation incorporating weak arbitrage pos-
sibilities using the weaker form of no-arbitrage termed as the Zero Curvature
condition. The equation incorporates an adjusted risk-free rate, influenced by
an arbitrage measure and option derivatives. Empirical findings based on the
iShares S&P 100 ETF American call options dataset demonstrate that captur-
ing weak arbitrage improves theoretical option price estimates, reducing dis-
crepancies and potential arbitrage opportunities. Further research can focus
on validating and enhancing the Information-based model using alternative
financial assets data.
