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No-arbitrage, state prices and trade in thin financial markets

Andrés Carvajal and Marek Weretka
Economic Theory
Vol. 50, No. 1 (May 2012), pp. 223-268
Published by: Springer
Stable URL: http://www.jstor.org/stable/41446276
Page Count: 46
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No-arbitrage, state prices and trade in thin financial markets
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Abstract

We examine how non-competitiveness in financial markets affects the choice of asset portfolios and the determination of equilibrium prices. In our model, potential arbitrage is conducted by a few highly specialized institutional investors who recognize and estimate the impact of their trades on financial prices. We apply a model of economic equilibrium, based on Weretka (http://www.ssc.wisc.edu/~mweretka/Research, 2007a), in which price effects are determined endogenously as part of the equilibrium concept. For the case in which markets allow for perfect insurance, we argue that the principle of no-arbitrage asset pricing is consistent with non-competitive behavior of the arbitragers and extend the fundamental theorem of asset pricing to the non-competitive setting.

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