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Replicating European Options with Prediction-Market Outcome Tokens

Article Quant Q&A · Author: uhbif19
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Summary

The document considers whether prices in a European options market and a prediction market on the same underlying and expiration can be compared for arbitrage. It proposes approximating an option payoff by combining prediction-market tokens that pay across adjacent outcome ranges. Weighting the tokens by their outcome intervals could create a payoff profile resembling an option across possible settlement values.

The idea is presented as a conceptual replication, not as a worked arbitrage. The author notes that purchasing many interval tokens may be impractical. The text does not specify token settlement conventions, available intervals, transaction costs, liquidity, collateral, or how to construct and hedge a portfolio. Those details would determine whether the payoff approximation is executable and whether any apparent pricing gap survives trading frictions.

Key ideas

  • A portfolio of range-based prediction tokens may approximate a European option payoff.
  • Comparing the replicated payoff’s cost with the option price could reveal a pricing discrepancy.
  • The proposed construction may require many outcome tokens and may be impractical.
  • The document leaves execution constraints, settlement details, and trading costs unaddressed.

Tags

OptionsArbitrageDerivatives pricingEvent-driven
Full text
# How to arbitrage options prices against prediction markets?


# How to arbitrage options prices against prediction markets?












Suppose we have both put/call European-style options market and price prediction market on same underlying asset and same expiration date.

How can one arbitrage one against the other?

It seems that you can emulate option by buying bunch of prediction tokens, like 1 for `[X,X+1)` price range, 2 for `[X+1,X+2)` and so on. This does not seem practical, but this rule should give some kind of arbitrage possibility

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.