Sublinear and Locally Sublinear Prices

Alessandro Plasmati

Università Commerciale “L. Bocconi”

Master of Science in Finance

Relatore: Prof. Erio Castagnoli

July, 2008

Alessandro Plasmati Sublinear and Locally Sublinear Prices 1/16

 Table of Contents
.1. Setting

.2. Linear Prices - No Arbitrage

.3. From Linear Prices to Sublinear Prices

.4. Sublinear Prices

No Arbitrage and Super-replications
Frictions on the Riskless Asset
.5. Locally Sublinear Prices
Sublinear Price Increments
Super-replications
Restricting L to L+
The Pricing Functional with Multiple Price Changes
Deriving and Interpreting cϕ

.6. Conclusions
Alessandro Plasmati Sublinear and Locally Sublinear Prices 2/16
Setting
One Period Discrete Time Model

• Ω = {ω1 , ω2 , . . . , ωi , . . . , ωm } is the set of states of the world

• The n financial assets y1 , y2 , . . . , yj , . . . , yn are traded on the
market
• yij represents the payoff of asset j if state i occurs
 
• Y = yij is the m × n matrix collecting all the yij ’s

• A vector a ∈ Rn will represent the number of units bought or

sold for each of the n assets
• π is the row vector containing the prices of the traded securities,
i.e.
π = [π(y1 ), π(y2 ), . . . , π(yj ), . . . , π(yn )]

Alessandro Plasmati Sublinear and Locally Sublinear Prices 3/16

Linear Prices - No Arbitrage
Assumption: Linear functionals map the payoffs of a given random
variable y in the vector space M ⊆ Rm to prices π(y) ∈ R.
Any linear functional can represented by a vector ϕ:

X
m
F(y) = yi F(ei ) = ϕ · y
i=1

Properties of a Linear Functional

.1. Additivity: F(x + y) = F(x) + F(y) = ϕ · x + ϕ · y = ϕ · (x + y)
.2. Homogeneity: F(αx) = αF(x) = α(ϕ · x)

Theorem (Fundamental Theorem of Finance)

Prices π 6= 0 do not allow for arbitrages of the first and of the second kind
if and only if there exists (at least) one (row) vector ϕ ∈ Rm
++ that solves
the linear system ϕY = π.

Alessandro Plasmati Sublinear and Locally Sublinear Prices 4/16

From Linear Prices to Sublinear Prices
Market Incompleteness

Whenever the market is incomplete (i.e. Y is singular), there exists

z∈/ M which can not be replicated by any portfolio a ∈ Rn : the
system Y · a = z does not admit solution.
As a result, any non-replicable contingent claim has not a linear
price. The system
ϕ·Y=π
is solved by infinitely many vectors ϕ, collected in the set L.
Solution: determine the minimum and maximum price consistent
with no arbitrage, if any, as
.1. Fa (z) = supϕ∈L++ ϕ · z = miny∈M {π(y) : y ≧ z}
.2. Fb (z) = −F(−z) = infϕ∈L++ ϕ · z = miny∈M {π(y) : y ≧ −z}
By the Hahn-Banach Theorem, the functional F(z) = supϕ∈L ϕ · z is
the unique sublinear extension on the whole Rm of the family of
linear functionals generated by the infinitely many vectors ϕ.

Alessandro Plasmati Sublinear and Locally Sublinear Prices 5/16

Sublinear Prices
bid-ask spreads possibly for all the traded assets on the market
A functional F is sublinear if, for any x, y ∈ M and α, β ≧ 0,

F(αx + βy) ≦ αF(x) + βF(y)

The properties of a sublinear functional:

• Subadditivity: F(x + y) ≦ F(x) + F(y)
• Positive Homogeneity: F(αx) = αF(x)

Different prices to buy and sell a given security yj are allowed: ask
prices are collected in the price vector πa , bid prices in πb . We solve
the system of linear inequalities

πb ≦ ϕ · Y ≦ πa

The set L collects all the solutions ϕ such that

L = {ϕ : πb ≦ ϕ · Y ≦ πa }

Alessandro Plasmati Sublinear and Locally Sublinear Prices 6/16

Sublinear Prices
No Arbitrage and Convenient Super-Replications

The distinction between bid and ask prices creates the possibility that
a random variable z be conveniently super-replicated, so that there
exists a ∈ Rn such that

Y·a≧z and F(Y · a) < F(z)

The properties of the pricing functional are used to assess the internal
coherence of the market:
positivity y ≧ 0 ⇒ F(y) ≧ 0 ask nai
monotonicity y ≧ 0 ⇒ −F(−y) ≧ 0 bid nsri
The interval [Fb (y), Fa (y)] generates three possible cases:
• [Fb (y), Fa (y)] ⊆ R+ : no convenient super-replications;

• [Fb (y), Fa (y)] overlaps with R+ but it is not included in it: only
no-arbitrage holds;
• [Fb (y), Fa (y)] * R+ : there are arbitrages and super-replications.

Alessandro Plasmati Sublinear and Locally Sublinear Prices 7/16

Sublinear Prices
Frictions on the Riskless Asset
The sublinear pricing functional F can be rewritten as:
F(y) = max Bp · y = max Ep [By]
p∈P+ p∈P+

B depends on p, unless the riskless asset is replicable, i.e. 1 ∈ M : in

this case,
F(y) = B max Ep [y]
p∈P+

In a sublinear setting, prices are maximal discounted expectations of

future payoffs.
Problem: When the riskless asset is affected by frictions, are buying
prices discounted with the buying price of the discount factor Ba ?
The answer is that it does not always happen.
Interpretation: the market acts as if a separation between securities
bought with own capital and securities bought with speculative capital
exists. Therefore, it’s either
F(y) = Ba Ep [y] or F(y) = Bb Ep [y]

Alessandro Plasmati Sublinear and Locally Sublinear Prices 8/16

Locally Sublinear Prices
Beyond Sublinear Prices: Removal of Positive Homogeneity
Simple Observation: imposing different prices for the purchase and
for the sale of a security is equivalent to setting a portfolio K = 0
whose components signal the point where the price system changes
from πb to πa .
Idea: set arbitrary values for the portfolio where prices change, so
that for a given K = [k1 k2 ] the price system changes from π 0 to π 00 ,
with π 00 ≥ π 0 for K ≥ 0.
Prices increasing with trade size are not positive homogeneous.
Example: assume n = m = 2 and K = [10 20]. K splits the a1 a2 plane (of
quantities) and the a1 a2 plane (of quantity increments) in four regions
a2 a2

A3 A4
A3 A4
translate K
−→ a1
20 K 0

A1 A2 A1 A2

a1
0 10

Alessandro Plasmati Sublinear and Locally Sublinear Prices 9/16

Locally Sublinear Prices
Sublinear Price Increments
After the translation of K to the origin, the price system changes in 0,
exactly as in the sublinear case.
Intuition: since we are in the plane of quantity increments with
respect to K, price increments should be sublinear. This result can
be proven.
For each of the four regions Ai of the plane a (possibly) different price
vector π i applies. As in the standard linear case, we can find

ϕi · Y = π i for i = 1, . . . , 4

The Fundamental Theorem of Finance can be applied to check for the

presence of arbitrages and super-replications.
If we define y = Y · K, and L is the convex hull generated by all the
ϕi , the pricing functional is given by

π(y) = π(y) + max ϕ · (y − y)

ϕ∈L+
| {z }
sublinear increments

Alessandro Plasmati Sublinear and Locally Sublinear Prices 10/16

Locally Sublinear Prices
Super-Replications
Example: Suppose that in A3 there exists ϕ3ω1 < 0 and that the random
variable x ∈ A3 . For any y ≥ x, it must be π(y) < π(x) because ϕ3ω1 < 0. We
can repeat the argument until we reach another area where prices are
coherent.
y2 y2

A3 A4 A3 A4

b b
x
b y(140, 180) b

400 400
3 3
b b y1 b b y1
−400 50 −400 50
−100 b
−100 b

A1 A2 A1 A2

Therefore, we conclude that, when convenient super-replications are possible

in a given area, any r.v. y in that area is conveniently super-replicated by the
random variables with a greater payoff in the negative state, up to the edge of
an adjacent area in which super-replications are not possible.
Alessandro Plasmati Sublinear and Locally Sublinear Prices 11/16
Locally Sublinear Prices
Restricting L to L+

The minimum cost super-replicating portfolio(s) delivers the price of

the r.v. when super-replications are not possible. Analogously, we can
price y with
π(y) = π(y) + max ϕ · (y − y)
ϕ∈L+

The convex hull L contains some negative state-prices: in order to

eliminate them, we need to derive L+ = L ∩ Rm + by considering the
intersections of the segments connecting the vectors ϕ with the axes.
ϕ2 ϕ2

ϕ3 (−0.05, 0.65) ϕ3 (−0.05, 0.65) ′

ϕ3 (0, 0.625)
b b
b

b
′′
ϕ3 (0, 0.5)

b b

ϕ1 (0.1, 0.2) L b
ϕ4 (1.15, 0.05) ϕ1 (0.1, 0.2) L+ b
ϕ4 (1.15, 0.05)
ϕ1 b b ϕ1
2′ ′′
ϕ (0.5, 0) ϕ2 (1.16667, 0)

b
ϕ2 (1.3, −0.4) b
ϕ2 (1.3, −0.4)

Alessandro Plasmati Sublinear and Locally Sublinear Prices 12/16

Locally Sublinear Prices
The Pricing Functional with Multiple Price Changes

In a market with multiple price changes, let us fix vertex yr of generic

Region r. The pricing functional in the 2m areas of which yr is a
vertex is
π(y) = π(yr ) + max ϕ · (y − yr )
where the maximum refers to all the areas of which yr is a vertex.
Moreover, if we consider also all the functionals relative to the other
ys , their prices are all smaller than or equal to π. In fact, those prices
are derived from price vectors surrounding ys which are smaller with
respect to the positive components of y − ys and greater with respect
to the negative components of y − ys .
Therefore, we can conclude that
h i
π(y) = max π(yr ) + max ϕ · (y − yr )
r ϕ∈Lr

Alessandro Plasmati Sublinear and Locally Sublinear Prices 13/16

Locally Sublinear Prices
Deriving and Interpreting cϕ
We can manipulate the functional in the following way:
h i
π(y) = max π(yr ) + max ϕ · (y − yr )
r ϕ∈Lr
n h io
= max max π(yr ) + ϕ · (y − yr )
r ϕ∈Lr
n h io
= max max π(yr ) + ϕ · y − ϕ · yr
r ϕ∈Lr
n  o
= max max ϕ · y + cϕ
r ϕ∈Lr
 
= max ϕ · y + cϕ
ϕ∈L
S
where L = Lr and cϕ = π(yr ) − ϕ · yr < 0.
The pricing functional is convex because it is the maximum of a family
of affine functionals. The constant cϕ is the value of the functional in
the origin: cϕ depends on the whole “layout” of the different grid
points, but also on the prices of the securities.
Alessandro Plasmati Sublinear and Locally Sublinear Prices 14/16
Locally Sublinear Prices
Deriving and Interpreting cϕ

Interpretation:
.1. Of all the possible prices supplied by the “intermediaries”, the
market sets the most expensive price as the the market price.
.2. The way in which the different intermediaries set their prices is
influenced by the incremental quantities they are willing to
supply: if they supply securities when the buyer has reached
their level of incremental supply, the price per unit is higher.
.3. The higher expense per unit is partially subsidized by the
intermediary by discounting a fixed amount cϕ from the total
price.
.4. Since market prices are set in a conservative way, a large cϕ will
be applied only in a situation where quantities are also large.

Alessandro Plasmati Sublinear and Locally Sublinear Prices 15/16

Conclusions
Locally sublinear models are versatile and, at a higher level of
complexity, they can accommodate a representation of a market in
which assets are not infinitely liquid, thereby removing positive
homogeneity from prices.
More qualitative insights can be gained by considering:

.1. Transparency: a transparent price system would be structured with a

sufficiently large number of grid points such that cϕ ’s variations
increase proportionally with size increments.
.2. Liquidity: the liquidity of a given asset is an indication of the ease with
which it can be bought or sold. In this respect, it is one of the
components of bid-ask spreads, and in our setting a lack of liquidity
would be signaled by prices increasing more than linearly with respect
to quantities.
.3. Market Depth: the constants cϕ indicate if and how variations in prices
make large trades difficult: for instance, we could compare two markets
based on values of the different cϕ , provided that they have the same K.

Alessandro Plasmati Sublinear and Locally Sublinear Prices 16/16