Flow-Based Arbitrage Pricing Theory

61 Pages Posted: 6 May 2022 Last revised: 20 Jun 2022

See all articles by Yu An

Yu An

Johns Hopkins Carey Business School

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

An, Yu, Flow-Based Arbitrage Pricing Theory (June 19, 2022). Available at SSRN: https://ssrn.com/abstract=4098607 or http://dx.doi.org/10.2139/ssrn.4098607

Yu An (Contact Author)

Johns Hopkins Carey Business School ( email )

100 International Drive
Baltimore, MD 21202
United States

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