Stochastic dominance option bounds and Nth order arbitrage opportunities

Huang, J (2004) Stochastic dominance option bounds and Nth order arbitrage opportunities. Working Paper. The Department of Accounting and Finance, Lancaster University.

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Abstract

In this paper we first derive Nth order stochastic dominance option bounds from concurrently expiring options. We show that these bounds are given by pricing kernels that have piecewise constant (N - 2)th derivatives. When these option bounds are violated there are Nth order arbitrage opportunities interpreted as (weighted average) conditional expected return comparison. We then establish a way to explore these arbitrage opportunities in option markets.