Arbitrage-Free Price-Update and Price-Impact Functions

Abstract:     
Consider a trading environment where trading volume affects security prices. We show that when the price impact is time stationary, only linear price-impact functions rule out arbitrage. This is true whether a single asset or a portfolio of assets is traded. When the temporary and permanent effects of trades on prices are independent, only the permanent price impact must be linear while the temporary one can be of a more general form. We also examine what arbitrage-free temporary and permanent price impacts must look like in a nonstationary framework.

JEL Classifications: D40, G12

Working Paper Series