Diversity and relative arbitrage in equity markets (Q1776022)

The descriptive notion of diversity for equity markets postulates that no individual stock ever be allowed to dominate the entire market in terms of relative capitalization. The present paper demonstrates that in the context of the standard Itô process and geometric-Brownian-motion-based model the diversity is indeed possible under appropriate, though rather delicate, conditions. The market portfolio is introduced in terms of which the notion of diversity and the allied successively weaker notions of weak diversity and asymptotic weak diversity are defined. The dynamics for the ranked market weights are studied, and in terms of them sufficient conditions for diversity are established. The conditions, roughly, are: the largest stock must have strongly negative rate of growth and all other stocks must have sufficiently high rates of growth. It is shown that in diverse markets relative arbitrage opportunities exist over arbitrary time-horizons: It is possible to construct two portfolios so that one outperforms the other with probability one. In particular, no equivalent martingale measure can exist for such markets. Also, mirror portfolios are introduced and diverse market models that contain a risk-free instrument and allow for general trading strategies (with short-selling and borrowing) are studied.