Fragility of Local Martingale Diffusion Models of Arbitrage and Bubbles
17 Pages Posted: 1 Jun 2011 Last revised: 3 Feb 2014
Date Written: January 29, 2014
For any positive diffusion with minimal regularity, there exists a semimartingale, with uniformly close paths, which is a martingale under an equivalent probability. As a result, in models of asset prices based on such diffusions, arbitrage and bubbles alike disappear under proportional transaction costs, or under small model misspecifications. Thus, local martingale models of arbitrage and bubbles are not robust to small trading and monitoring frictions.
Keywords: Arbitrage, Bubbles, Transaction Costs, Local Martingales
JEL Classification: G12
Suggested Citation: Suggested Citation