Will the True Marginal Investor Please Stand Up?: Asset Prices with Immutable Security Trading by Investors

Abstract

The important and highly influential Amihud and Mendelson (1986) model of asset pricing incorporating immutable security trading by a continuum of investors/traders is unnecessarily opaque because of a flaw in the numerical simulation which I correct. Moreover, the exposition by Kane (1994) and Bodie, Kane and Marcus (2002) also fails to faithfully present the model. Putting aside these presentational issues, I show that the model is flawed because the marginal investor, on whom the analysis rests, cannot be identified. More fundamentally, the model fails to identify the benefits of trading whilst taking account of the costs. This one-sided treatment means that the model as it stands cannot be used to make valid predictions of the impact of transaction costs on asset prices.