A Theory of Inefficient Quotes: Empirical Evidence in Options Markets

In an arbitrage-free economy with non-zero bid-ask spreads, the presence of payoffs, whose price is lower than the price of another payoff where the former dominates the latter, can not be discarded in general. However, their presence is a true market anomaly when the former price corresponds to trivial portfolios which involve buying or selling one unit of the basis assets. We refer to these prices as inefficient quotes and we characterize their absence by imposing certain conditions on the set of admissible Stochastic Discount Factors. A measure of overall quote inefficiency is also introduced. We report, in an empirical study, evidence that indicates that in options markets, both the frequency and the magnitude of these inefficiencies, are substantial. Also, we find puzzling patterns in the behavior of these inefficiencies.