Limits of Arbitrage, Sentiment and Pricing Kernal: Evidences from Index Options

This paper provides evidences that there are limits to arbitrage in the index options market, and that the pricing kernel depends investor sentiment. First, we find that sentiment of the institutional investors is a significant determinant for index options demand, as well as the deviation of the S&P 500 index level from the fundamentals. Second, the institutional sentiment and the index put-call ratio significantly affect the relative valuations of index options and the risk-neutral density of index returns. Their impact becomes stronger when there are more impediments to arbitrage activities in the index options. Our results are robust and can not be explained by the rational perfect-market models. Further, index mispricing also influences index option valuations. Traditional models need to be extended to explain our findings.