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Seminar on Probability and Statistics Friday November 19 2004 Tokyo 128 3:00-4:10 pm
Liquidity risk and arbitrage pricing theory
Philip PROTTER Cornell University Abstract We review the classical theory of financial markets and explain
that in order to work, they 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. This
talk is based on joint work with U. Cetin and R. Jarrow.
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