Static-arbitrage bounds on the prices of basket options via linear programming

Javier Pena (jfpandrew.cmu.edu)
Juan Vera (jveraandrew.cmu.edu)
Luis Zuluaga (lzuluagaunb.ca)

Abstract: We show that the problem of computing sharp upper and lower static-arbitrage bounds on the price of a European basket option, given the prices of other similar options, can be cast as a linear program (LP). The LP formulations readily yield super-replicating (sub-replicating) strategies for the upper (lower) bound problem. The dual counterparts of the LP formulations in turn yield underlying asset price distributions that replicate the given option prices, and the bound on the new basket option's price. In the special case when the given option prices are those of vanilla options on the underlying assets, we show that the LP formulations admit further simplifications. In particular, for the upper bound problem we derive closed-form formulas for the basket's price bound, and for the corresponding super-replicating strategy. In addition, our LP approach admits efficient modeling of additional features such as basket options with negative weights, bid/ask spreads, transaction costs, and diversification constraints. We provide numerical experiments to illustrate some of our results.

Keywords: arbitrage bounds, option pricing, super/sub-replication

Category 1: Applications -- OR and Management Sciences

Category 2: Linear, Cone and Semidefinite Programming (Linear Programming )

Category 3: Infinite Dimensional Optimization (Semi-infinite Programming )

Citation: Working Paper, Tepper School of Business, Carnegie Mellon University

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Entry Submitted: 07/19/2006
Entry Accepted: 07/21/2006
Entry Last Modified: 07/19/2006

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