Unraveling Market Inefficiencies: Weak Arbitrage and the Information-Based Model for Option Pricing

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.