Arbitrage Restrictions Across Financial Markets: Theory, Methodology and Tests

Abstract

The Cox, Ingersoll and Ross [1985a] general equilibrium model is extended by allowing the representative investor to trade in a batch call option market with execution price uncertainty. Necessary restrictions on the execution price uncertainty for the original equilibrium to remain intact are derived. They take the form of moment conditions in the pricing error (defined as the difference between the observed call price and the theoretical call price that would obtain in the absence of execution price uncertainty). The moment conditions can easily be estimated and tested using a version of the Method of Simulation Moments (MSM). In it, simulation estimates, obtained by discretely approximating the risk-neutral processes of the underlying stock price and the interest rate, are substituted for analytically unknown call prices. The asymptotics and other aspects of the MSM estimator are discussed. The model is tested on transaction prices from the Berkeley Options Data Base.

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