Abstract
To analyze the economic significance of pricing errors of stock index options, a system of linear inequalities is developed which completely characterizes all risk arbitrage opportunities which arise if a well-behaved pricing kernel does not exist. The Stochastic Arbitrage system can account for market imperfections in the form of transactions costs and general portfolio restrictions. An active trading strategy based on the Stochastic Arbitrage system for front-month S&P500 stock index options yields significant abnormal returns out of sample, for small-scale portfolios. However, outperformance seems elusive if the strategy is scaled up and market depth is taken into account.
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