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Frontiers in Finance and Economics is a UGC APPROVED International Journal of Research

Option Pricing with Long-Short Spreads

Pengguo Wang
This paper addresses no-arbitrage pricing of options in a market with long-short spreads. First, it characterizes the term structure of no-arbitrage valuation in a frictional capital market. It shows that no arbitrage opportunities imply, and are implied by, the existence of an equivalent probability measure, under which the discounted long prices of traded securities are supermartingales, and the discounted short prices are submartingales. Second, the classic option-pricing model is generalized to a more realistic and imperfect capital market. It is shown that, in the absence of arbitrage opportunities, the equilibrium price of a call or put option must lie within an arbitrage-band. Two general partial differential equations (PDEs), which long and short prices of a contingent claim must satisfy, are identified. Third, it shows that the long-short spreads in option-pricing have important implications for portfolio hedging.
Keywords: option pricing, no-arbitrage, long-short spreads, martingale measure, hedging
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