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Liquidity risk and arbitrage pricing theory

In: Financial Derivatives Pricing Selected Works of Robert Jarrow

Author

Listed:
  • Umut Çetin

    (Technische Universität Wien, Institut für Finanz- und Versicherungsmathematik, Wiedner Hauptstr. 8–10, 1040 Vienna, Austria)

  • Robert A. Jarrow

    (Johnson Graduate School of Management, Cornell University, Ithaca, NY, 14853, USA)

  • Philip Protter

    (School of Operations Research, Cornell University, Ithaca, NY, 14853-3801, USA)

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.

Suggested Citation

  • Umut Çetin & Robert A. Jarrow & Philip Protter, 2008. "Liquidity risk and arbitrage pricing theory," World Scientific Book Chapters, in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 8, pages 153-183, World Scientific Publishing Co. Pte. Ltd..
    • Handle: RePEc:wsi:wschap:9789812819222_0008
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    Keywords

    Derivatives; Options; Hedging; HJM; Black–Scholes; Forwards; Futures; Martingale Measure; Calls; Puts; Market Manipulation; Margin Requirements;
    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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