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The law of one price in quadratic hedging and mean-variance portfolio selection

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  • Alev{s} v{C}ern'y
  • Christoph Czichowsky

Abstract

The \emph{law of one price (LOP)} broadly asserts that identical financial flows should command the same price. We show that, when properly formulated, LOP is the minimal condition for a well-defined mean--variance portfolio allocation framework without degeneracy. Crucially, the paper identifies a new mechanism through which LOP can fail in a continuous-time $L^2(P)$ setting without frictions, namely `trading from just before a predictable stopping time', which surprisingly identifies LOP violations even for continuous price processes. Closing this loophole allows to give a version of the ``Fundamental Theorem of Asset Pricing'' appropriate in the quadratic context, establishing the equivalence of the economic concept of LOP with the probabilistic property of the existence of a local $\scr{E}$-martingale state price density. The latter provides unique prices for all square-integrable contingent claims in an extended market and subsequently plays an important role in mean-variance portfolio selection and quadratic hedging.

Suggested Citation

  • Alev{s} v{C}ern'y & Christoph Czichowsky, 2022. "The law of one price in quadratic hedging and mean-variance portfolio selection," Papers 2210.15613, arXiv.org, revised Jan 2024.
    • Handle: RePEc:arx:papers:2210.15613
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