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arXiv · 2004.12394

A constraint-based notion of illiquidity

Thomas Krabichler·Josef Teichmann
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Abstract

This article introduces a new mathematical concept of illiquidity that goes hand in hand with credit risk. The concept is not volume- but constraint-based, i.e., certain assets cannot be shorted and are ineligible as num\'eraire. If those assets are still chosen as num\'eraire, we arrive at a two-price economy. We utilise Jarrow & Turnbull's foreign exchange analogy that interprets defaultable zero-coupon bonds as a conversion of non-defaultable foreign counterparts. In the language of structured derivatives, the impact of credit risk is disabled through quanto-ing. In a similar fashion, we look at bond prices as if perfect liquidity was given. This corresponds to asset pricing with respect to an ineligible num\'eraire and necessitates F\"ollmer measures.

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Thomas Krabichler, Josef Teichmann. 2020-04-26. A constraint-based notion of illiquidity. https://arxiv.org/abs/2004.12394

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