We propose a dynamic theory of banking where deposits play the role of productive capital as in the classical Q-theory of investment for non-financial firms. A key conceptual innovation of our theory is that the stock of deposits cannot be perfectly controlled by the bank. Demand deposit...

This paper provides two modified pricing PDEs for a general European option under liquidity risk, by which two modified hedges are derived. It is shown that the hedge errors of the two modified hedges approach zero as the trading time interval converges to zero inclusive of liquidity costs. An...

We formulate a robust theory of liquidity and risk management based on two fundamental frictions: 1) the entrepreneur cannot alienate his human capital, and 2) the entrepreneur worries about model uncertainty and seek robust decisions. In line with max-min expected utility, a robust entrepreneur...

The 2008 financial crisis exemplifies significant uncertainties in corporate financing conditions. We develop a unified dynamic q-theoretic framework where firms have both a precautionary-savings motive and a market-timing motive for external financing and payout decisions, induced by stochastic...