Liquidity Risk and Arbitrage Pricing Theory

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Liquidity Risk and Arbitrage Pricing Theory

by Umut Çetin of the Technical University of Vienna,
Robert A. Jarrow of Cornell University, and
Philip Protter of Cornell University

August 2004

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 modeling 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: Liquidity risk.

Published in: Finance and Stochastics, Vol. 8, No. 3, (August 2004), pp. 311–341.

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