Liquidity risk and arbitrage pricing theory

Umut Çetin (), Robert Jarrow () and Philip Protter ()

Finance and Stochastics, 2004, vol. 8, issue 3, 341 pages

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

Keywords: Illiquid markets; fundamental theorems of asset pricing; approximately complete markets; approximation of stochastic integrals (search for similar items in EconPapers)
Date: 2004
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DOI: 10.1007/s00780-004-0123-x

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