Rational Asset Pricing Implications from Realistic Trading Frictions

Abstract

We study a simple rational expectations model whose asset pricing implications address some of the mispricings, informational inefficiencies and overreactions observed in real markets, without a need to resort to behavioural assumptions. We accomplish this by relying on the plausible joint frictions of immediacy risk (execution risk) and of asset-specific orders (the demand function for asset 'a' cannot be made contingent on the price of any asset other than 'a'). These induce allocational and informational inefficiencies akin to the ones observed in reality. Furthermore, the decision making entity becomes segmented into distinct "trading desks."

Keywords: Arbitrage, Trading Frictions, Asset Pricing, Informational Inefficiencies

JEL Classification: G11, G12, G14