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

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 option values based on the strict assumption of no arbitrage. In addition, its assumptions 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 possibilities 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 capturing weak arbitrage improves theoretical option price estimates, reducing discrepancies and potential arbitrage opportunities. Further research can focus on validating and enhancing the Information-based model using alternative financial assets data.