Liquidity risk and arbitrage pricing theory

Umut Çetin, Robert Jarrow () and Philip Protter
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Umut Çetin: Technische Universität Wien, Institut für Finanz- und Versicherungsmathematik, Wiedner Hauptstr. 8–10, 1040 Vienna, Austria
Philip Protter: School of Operations Research, Cornell University, Ithaca, NY, 14853-3801, USA

Chapter 8 in Financial Derivatives Pricing:Selected Works of Robert Jarrow, 2008, pp 153-183 from World Scientific Publishing Co. Pte. Ltd.

Abstract: AbstractClassical 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.

Keywords: Derivatives; Options; Hedging; HJM; Black–Scholes; Forwards; Futures; Martingale Measure; Calls; Puts; Market Manipulation; Margin Requirements (search for similar items in EconPapers)
Date: 2008
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Journal Article: Liquidity risk and arbitrage pricing theory (2004)
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