A recently proposed model (by Ilinski et al.) for the dynamics of intermediate deviations from equilibrium of financial markets ( “virtual” arbitrage returns) is incorporated within an equilibrium (arbitrage-free) pricing method for derivatives on securities (e.g. stocks) using an equivalence to option pricing theory with stochastic interest rates. Making the arbitrage return a component of a fictitious short-term interest rate (while the real risk-free rate is assumed to be constant) and thus… CONTINUE READING