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Exact arbitrage, well-diversified portfolios and asset pricing in large markets

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  • Khan, M. Ali
  • Sun, Yeneng

Abstract

In a model of a nancial market with an atomless continuum of assets, we give a precise and rigorous meaning to the intuitive idea of a \well-diversi ed' portfolio and to a notion of \exact arbitrage'. We show this notion to be necessary and su cient for an APT pricing formula to hold, to be strictly weaker than the more conventional notion of \asymptotic arbitrage', and to have novel implications for the continuity of the cost functional as well as for various versions of APT asset pricing. We further justify the idealized measure-theoretic setting in terms of a pricing formula based on \essential' risk, one of the three components of a tri-variate decomposition of an asset's rate of return, and based on a speci c index portfolio constructed from endogenously extracted factors and factor loadings. Our choice of factors is also shown to satisfy an optimality property that the rst m factors always provide the best approximation. We illustrate how the concepts and results translate to markets with a large but nite number of assets, and relate to previous work.
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  • Khan, M. Ali & Sun, Yeneng, 2003. "Exact arbitrage, well-diversified portfolios and asset pricing in large markets," Journal of Economic Theory, Elsevier, vol. 110(2), pages 337-373, June.
  • Handle: RePEc:eee:jetheo:v:110:y:2003:i:2:p:337-373
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    Cited by:

    1. Laurence Carassus & Miklos Rasonyi, 2019. "Risk-neutral pricing for APT," Papers 1904.11252, arXiv.org, revised Oct 2020.
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    3. Birge, John R. & Yang, Song, 2007. "A model for tax advantages of portfolios with many assets," Journal of Banking & Finance, Elsevier, vol. 31(11), pages 3269-3290, November.
    4. Michailidis, G., 2009. "Multivariate methods in examining macroeconomic variables effect on Greek stock market returns, 1997-2004," Applied Econometrics and International Development, Euro-American Association of Economic Development, vol. 9(1).
    5. Chen Zhang & Wei Yan, 2019. "Spot Market Mechanism Design for the Electricity Market in China Considering the Impact of a Contract Market," Energies, MDPI, vol. 12(6), pages 1-23, March.

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