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| Liquidity Risk and Arbitrage Pricing Theory by Umut Çetin of the Technical University of Vienna, 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. Books Referenced in this paper: (what is this?)
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