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Arbitrage and deflators in illiquid markets

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  • Teemu Pennanen

Abstract

This paper presents a stochastic model for discrete-time trading in financial markets where trading costs are given by convex cost functions and portfolios are constrained by convex sets. The model does not assume the existence of a cash account/numeraire. In addition to classical frictionless markets and markets with transaction costs or bid-ask spreads, our framework covers markets with nonlinear illiquidity effects for large instantaneous trades. In the presence of nonlinearities, the classical notion of arbitrage turns out to have two equally meaningful generalizations, a marginal and a scalable one. We study their relations to state price deflators by analyzing two auxiliary market models describing the local and global behavior of the cost functions and constraints.

Suggested Citation

  • Teemu Pennanen, 2008. "Arbitrage and deflators in illiquid markets," Papers 0807.2526, arXiv.org, revised Apr 2009.
    • Handle: RePEc:arx:papers:0807.2526
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    Cited by:

    1. Pekka Malo & Teemu Pennanen, 2012. "Reduced form modeling of limit order markets," Quantitative Finance, Taylor & Francis Journals, vol. 12(7), pages 1025-1036, April.

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