Liquidity Risk and Arbitrage Pricing Theory
by Umut Çetin of the Technical University of Vienna,
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.