Limits to Arbitrage and the Skewness Risk Premium in Options Markets
Option prices, particularly those of out-of-the-money equity index puts, are difficult to justify in a no-arbitrage framework. This paper shows how limits to arbitrage affect the relative pricing of out-of-the-money put vs. call options (option-implied skewness). Decomposing the price of skewness into ex-post realized skewness and a skewness risk premium in commodity futures options markets, I find that the skewness risk premium increases, but realized skewness remains unchanged, when i) arbitrageurs hold larger net long positions in options, and ii) long positions in the underlying asset are concentrated among fewer traders. In addition, the first effect is stronger when arbitrageurs are more financially constrained. Trading strategies designed to theoretically exploit these limits yield up to 2 percent per month after risk-adjustment. The results provide solid support for the existence of a limits to arbitrage effect on option prices as well as option returns.