Resolving Asset Pricing Puzzles with Price Impact

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 cádlág (right-continuous with left limits) and cáglád (left-continuous with right limits) paths of bounded quadratic variation and of finitely many jumps. That is, cádlág and cáglád predictable trading strategies of infinite variation, with finitely many jumps and of finite quadratic variation are allowed in our setting. Restricting ourselves to cáglád 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 nonlinear in the order size.

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How Much Would You Pay to Resolve Long-Run Risk?

The American Economic Review ◽

10.1257/aer.104.9.2680 ◽

2014 ◽

Vol 104 (9) ◽

pp. 2680-2697 ◽

Cited By ~ 86

Author(s):

Larry G. Epstein ◽

Emmanuel Farhi ◽

Tomasz Strzalecki

Keyword(s):

Asset Pricing ◽

Temporal Resolution ◽

Recursive Utility ◽

Elasticity Of Intertemporal Substitution ◽

Careful Scrutiny ◽

Long Run ◽

Quantitative Properties ◽

Long Run Risks ◽

Asset Pricing Puzzles ◽

Long Run Risk

Though risk aversion and the elasticity of intertemporal substitution have been the subjects of careful scrutiny, the long-run risks literature as well as the broader literature using recursive utility to address asset pricing puzzles has ignored the full implications of their parameter specifications. Recursive utility implies that the temporal resolution of risk matters and a quantitative assessment thereof should be part of the calibration process. This paper gives a sense of the magnitudes of implied timing premia. Its objective is to inject temporal resolution of risk into the discussion of the quantitative properties of long-run risks and related models. (JEL D81, G11, G12)

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