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Liquidity risk and arbitrage pricing theory

Author

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  • Umut Çetin
  • Robert Jarrow
  • Philip Protter

Abstract

Classical theories of financial markets assume an infinitely liquid market and that all traders act as price takers. This theory is a good approximation for highly liquid stocks, although even there it does not apply well for large traders or for modelling transaction costs. We extend the classical approach by formulating a new model that takes into account illiquidities. Our approach hypothesizes a stochastic supply curve for a security’s price as a function of trade size. This leads to a new definition of a self-financing trading strategy, additional restrictions on hedging strategies, and some interesting mathematical issues. Copyright Springer-Verlag Berlin/Heidelberg 2004

Suggested Citation

  • Umut Çetin & Robert Jarrow & Philip Protter, 2004. "Liquidity risk and arbitrage pricing theory," Finance and Stochastics, Springer, vol. 8(3), pages 311-341, August.
    • Handle: RePEc:spr:finsto:v:8:y:2004:i:3:p:311-341
    DOI: 10.1007/s00780-004-0123-x
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    Keywords

    Illiquid markets; fundamental theorems of asset pricing; approximately complete markets; approximation of stochastic integrals;
    All these keywords.

    JEL classification:

    • B26 - Schools of Economic Thought and Methodology - - History of Economic Thought since 1925 - - - Financial Economics
    • O16 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Financial Markets; Saving and Capital Investment; Corporate Finance and Governance
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy

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