Free Lunches with Vanishing Risks Most Likely Exist

TL;DR

This paper challenges the common belief in finance that free lunches with vanishing risk do not exist, demonstrating their presence through a precise hedging strategy in real markets, and discussing theoretical accommodation.

Contribution

It provides empirical evidence that FLVRs can exist in real markets and offers a theoretical framework to incorporate them.

Findings

Successfully hedged an extreme-maturity zero-coupon bond

Constructed a portfolio with zero initial wealth yielding positive payoff with positive probability

Supports the existence of FLVRs in real markets and their theoretical integration

Abstract

The hypothesis that there do not exist free lunches with vanishing risk (FLVRs) in the real market underpins the popular risk-neutral pricing and hedging methodology in quantitative finance. The paper documents the fact that this hypothesis can be safely rejected. It performs extremely accurately the hedging of an extreme-maturity zero-coupon bond (ZCB). This hedge is part of a portfolio that starts with zero initial wealth and invests dynamically in a total return stock market index and the savings account to generate at the maturity date of the extreme-maturity ZCB a strictly positive amount with strictly positive probability, which represents an FLVR. The fact that FLVRs naturally exist in the real market can be accommodated theoretically under the benchmark approach.