Limits of Arbitrage and Primary Risk Taking in Derivative Securities

Abstract

Classic option pricing theory values a derivative contract via dynamic replication, and views the derivative as redundant relative to the replicating portfolio. In practice, while dynamic replication proves to be highly effective in drastically reducing the risks in derivative investments, the remaining risks can still be large and significant due to practical limits of arbitrage. Because of these limits, derivative securities can play primary roles in risk allocation and investors can demand risk premiums for taking these primary risks. This paper documents the effectiveness of delta hedging on U.S. stock options under practical situations, examines the cross-sectional and intertemporal variation of investment returns from writing options on different stocks, and attributes the return variation to variations in primary risk exposures in the delta-hedged option investments.