Binary markets under transaction costs

TL;DR

This paper investigates binary market models with transaction costs, characterizing the critical transaction cost level for arbitrage absence and providing explicit formulas for it in specific market settings.

Contribution

It introduces a characterization of the critical transaction cost _c and explicit formulas for _c in homogeneous binary markets, advancing understanding of arbitrage in markets with frictions.

Findings

Identified the smallest _c for arbitrage-free markets.

Derived explicit formulas for _c in homogeneous markets.

Showed the transition phase =_c is empty if and only if the frictionless market has arbitrage.

Abstract

The goal of this work is to study binary market models with transaction costs, and to characterize their arbitrage opportunities. It has been already shown that the absence of arbitrage is related to the existence of \lambda-consistent price systems (\lambda-CPS), and, for this reason, we aim to provide conditions under which such systems exist. More precisely, we give a characterization for the smallest transaction cost \lambda_c (called "critical" \lambda) starting from which one can construct a \lambda-consistent price system. We also provide an expression for the set M(\lambda) of all probability measures inducing \lambda-CPS. We show in particular that in the transition phase "\lambda=\lambda_c" these sets are empty if and only if the frictionless market admits arbitrage opportunities. As an application, we obtain an explicit formula for \lambda_c depending only on the parameters of the model for homogeneous and also for some semi-homogeneous binary markets.