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Implicit transaction costs and the fundamental theorems of asset pricing

Erindi Allaj

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Abstract: This paper studies arbitrage pricing theory in financial markets with implicit transaction costs. We extend the existing theory to include the more realistic possibility that the price at which the investors trade is dependent on the traded volume. The investors in the market always buy at the ask and sell at the bid price. Implicit transaction costs are composed of two terms, one is able to capture the bid-ask spread, and the second the price impact. Moreover, a new definition of a self-financing portfolio is obtained. The self-financing condition suggests that continuous trading is possible, but is restricted to predictable trading strategies having c\'adl\'ag (right-continuous with left limits) and c\'agl\'ad (left-continuous with right limits) paths of bounded quadratic variation and of finitely many jumps. That is, c\'adl\'ag and c\'agl\'ad predictable trading strategies of infinite variation, with finitely many jumps and of finite quadratic variation are allowed in our setting. Restricting ourselves to c\'agl\'ad predictable trading strategies, we show that the existence of an equivalent probability measure is equivalent to the absence of arbitrage opportunities, so that the first fundamental theorem of asset pricing (FFTAP) holds. It is also shown that the use of continuous and bounded variation trading strategies can improve the efficiency of hedging in a market with implicit transaction costs. To better understand how to apply the theory proposed we provide an example of an implicit transaction cost economy that is linear and non-linear in the order size.

Date: 2013-10, Revised 2017-07
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