The Cost of a Free Lunch: Evidence from U.S. Derivatives Markets

TL;DR

This paper investigates the costs and frictions in U.S. derivatives markets by analyzing option-implied discount factors, carry gaps, and their relation to market risks and trading frictions.

Contribution

It introduces a novel reduced-form model linking carry gaps to implementation risk, trading frictions, and financial conditions using high-frequency options data.

Findings

Carry gaps are systematically related to market risks and trading frictions.

Enforcing put-call parity involves path-dependent costs not visible in prices.

The model's coefficients are stable across different validation periods.

Abstract

Put-call parity is a terminal-payoff identity; quoted residuals against traded futures are near zero. Yet enforcing parity is path-dependent, exposing arbitrageurs to daily settlement, margin, and finite capital. Using minute-level NBBO data on S&P 500 and Russell 2000 options, I extract option-implied discount factors, compare them with the OIS curve, and construct an annualized carry gap. A reduced-form specification centered on a volatility times sqrt(tau) path-risk term links the carry gap to implementation risk, trading frictions, and financial conditions, with coefficient signs stable across leave-one-year-out validation. The carry gap is an implementation wedge invisible in price space but systematic in carry space.