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A two price theory of financial equilibrium with risk management implications

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  • Dilip Madan

Abstract

Financial primitives are introduced to define acceptable loss exposures when demands and supplies are defined on differing event spaces. Acceptable loss exposures are modeled by a convex cone of random variables containing the nonnegative random variables. The resulting financial equilibrium defines in general a two price economy. Analytical procedures for identifying the two prices are described. The size of the two price economy is fundamentally determined by the financial system that determines the size of the cone of acceptable losses. There are implications for accounting and risk management as liabilities would typically be valued at ask while assets are valued at bid with no data available on bidirectional prices for anything. Marking to market in such financial economies is at best marking to two price economies. Copyright Springer-Verlag 2012

Suggested Citation

  • Dilip Madan, 2012. "A two price theory of financial equilibrium with risk management implications," Annals of Finance, Springer, vol. 8(4), pages 489-505, November.
    • Handle: RePEc:kap:annfin:v:8:y:2012:i:4:p:489-505
    DOI: 10.1007/s10436-012-0200-7
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    Citations

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    Cited by:

    1. Florence Guillaume & Gero Junike & Peter Leoni & Wim Schoutens, 2019. "Implied liquidity risk premia in option markets," Annals of Finance, Springer, vol. 15(2), pages 233-246, June.
    2. Dilip B. Madan & Wim Schoutens & King Wang, 2017. "Measuring And Monitoring The Efficiency Of Markets," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 20(08), pages 1-32, December.
    3. Dilip B. Madan & Yazid M. Sharaiha, 2015. "Option overlay strategies," Quantitative Finance, Taylor & Francis Journals, vol. 15(7), pages 1175-1190, July.
    4. Dilip B. Madan, 2016. "Adapted hedging," Annals of Finance, Springer, vol. 12(3), pages 305-334, December.
    5. Mehdi Vazifedan & Qiji Jim Zhu, 2020. "No-Arbitrage Principle in Conic Finance," Risks, MDPI, vol. 8(2), pages 1-34, June.
    6. Dilip B. Madan, 2016. "Conic Portfolio Theory," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 19(03), pages 1-42, May.
    7. Madan, Dilip B. & Schoutens, Wim, 2013. "Systemic risk tradeoffs and option prices," Insurance: Mathematics and Economics, Elsevier, vol. 52(2), pages 222-230.
    8. Ernst Eberlein & Dilip Madan & Martijn Pistorius & Wim Schoutens & Marc Yor, 2014. "Two price economies in continuous time," Annals of Finance, Springer, vol. 10(1), pages 71-100, February.
    9. Madan, Dilip B., 2014. "Modeling and monitoring risk acceptability in markets: The case of the credit default swap market," Journal of Banking & Finance, Elsevier, vol. 47(C), pages 63-73.
    10. Dilip B. Madan, 2018. "Financial equilibrium with non-linear valuations," Annals of Finance, Springer, vol. 14(2), pages 211-221, May.
    11. Thomas Krabichler & Josef Teichmann, 2020. "A constraint-based notion of illiquidity," Papers 2004.12394, arXiv.org.
    12. Carr, Peter & Madan, Dilip B. & Melamed, Michael & Schoutens, Wim, 2016. "Hedging insurance books," Insurance: Mathematics and Economics, Elsevier, vol. 70(C), pages 364-372.
    13. Siu, Tak Kuen, 2023. "European option pricing with market frictions, regime switches and model uncertainty," Insurance: Mathematics and Economics, Elsevier, vol. 113(C), pages 233-250.
    14. Dilip Madan, 2015. "Asset pricing theory for two price economies," Annals of Finance, Springer, vol. 11(1), pages 1-35, February.
    15. Dilip B. Madan, 2012. "From credit valuation adjustments to credit capital commitments," Quantitative Finance, Taylor & Francis Journals, vol. 12(6), pages 839-845, April.
    16. Dilip B Madan, 2016. "Marking to two-price markets," Journal of Asset Management, Palgrave Macmillan, vol. 17(2), pages 100-118, March.
    17. Yuhong Xu, 2014. "Robust valuation and risk measurement under model uncertainty," Papers 1407.8024, arXiv.org.

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    More about this item

    Keywords

    Liability valuation; Capital reserves; Taxpayer put option; Risk weighted assets; D52; D53; G10; G12; G13;
    All these keywords.

    JEL classification:

    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
    • D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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