Flow-Based Arbitrage Pricing Theory
61 Pages Posted: 6 May 2022 Last revised: 20 Jun 2022
Date Written: June 19, 2022
I generalize the canonical arbitrage-pricing framework to study how uninformative flows generate price impacts for the cross section of assets. I develop the flow-based stochastic discount factor (F-SDF) approach to price impacts. F-SDF is the flow-induced changes in the standard SDF. I define any portfolio's price impact ratio as the portfolio's price impact over the portfolio's fundamental risk. I prove that the maximum price impact ratio over all portfolios equals the minimum volatility of F-SDF. I show that portfolio-flow construction runs in the opposite direction of portfolio-return construction. I formalize intuitions for reasonable price impacts via a new restriction, Irrelevance of Uncorrelated Flows. My restriction relaxes the equal-price-of-risk constraint of static CARA-Gaussian model. I derive the linear factor model of price impacts, under which price impacts depend only on common flows but not on idiosyncratic flows.
Keywords: arbitrage pricing, flow, price impact, risk, stochastic discount factor
JEL Classification: G12
Suggested Citation: Suggested Citation