Flow-Based Arbitrage Pricing Theory

Yu An - Apr 30, 2023

Working Paper No.  00099-00

I introduce a new approach, model, and definition for analyzing demand effects in asset pricing. My approach generalizes arbitrage pricing, and avoids making any parametric assumptions on utility function and payoff distribution, which are commonly found in equilibrium literature. My approach also reveals and relaxes an unrealistic cross-sectional restriction on price impacts in the literature's quadratic-normal setup. In my model, price impacts between underlying assets occur through factors, which connect to these assets through the covariance structure of noisy flows and fundamental risks. Specifically, I develop a new definition for factor-level demand elasticity, highlighting that the conventional definition is ill-defined.

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