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The Law of Minimal Price

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Abstract

This paper introduces a realistic, generalized market modeling framework for which the Law of One Price no longer holds. Instead the Law of the Minimal Price will be derived, which for contingent claims with long term to maturity may provide significantly lower prices than suggested under the currently prevailing approach. This new law only requires the existence of the numeraire portfolio, which turns out to be the portfolio that maximizes expected logarithmic utility. In several ways it will be shown that the numeraire portfolio cannot be outperformed by any nonnegative portfolio. The new Law of the Minimal Price leads directly to the real world pricing formula, which uses the numeraire portfolio as numeraire and the real world probability for calculating conditional expectations. The cost efficient pricing and hedging of extreme maturity zero coupon bonds illustrates the new law in the context of the US market.

Suggested Citation

  • Eckhard Platen, 2008. "The Law of Minimal Price," Research Paper Series 215, Quantitative Finance Research Centre, University of Technology, Sydney.
  • Handle: RePEc:uts:rpaper:215
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    File URL: https://www.uts.edu.au/sites/default/files/qfr-archive-02/QFR-rp215.pdf
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    References listed on IDEAS

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    1. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
    2. Merton, Robert C, 1973. "An Intertemporal Capital Asset Pricing Model," Econometrica, Econometric Society, vol. 41(5), pages 867-887, September.
    3. Harry M. Markowitz, 2011. "Investment for the Long Run: New Evidence for an Old Rule," World Scientific Book Chapters,in: THE KELLY CAPITAL GROWTH INVESTMENT CRITERION THEORY and PRACTICE, chapter 35, pages 495-508 World Scientific Publishing Co. Pte. Ltd..
    4. Eckhard Platen, 2006. "A Benchmark Approach To Finance," Mathematical Finance, Wiley Blackwell, vol. 16(1), pages 131-151.
    5. Harrison, J. Michael & Kreps, David M., 1979. "Martingales and arbitrage in multiperiod securities markets," Journal of Economic Theory, Elsevier, vol. 20(3), pages 381-408, June.
    6. Eckhard Platen, 2004. "A Benchmark Framework for Risk Management," World Scientific Book Chapters,in: Stochastic Processes And Applications To Mathematical Finance, chapter 15, pages 305-335 World Scientific Publishing Co. Pte. Ltd..
    7. Robert C. Merton, 2005. "Theory of rational option pricing," World Scientific Book Chapters,in: Theory Of Valuation, chapter 8, pages 229-288 World Scientific Publishing Co. Pte. Ltd..
    8. Eckhard Platen & Hardy Hulley, 2008. "Hedging for the Long Run," Research Paper Series 214, Quantitative Finance Research Centre, University of Technology, Sydney.
    9. Eckhard Platen, 2001. "Arbitrage in Continuous Complete Markets," Research Paper Series 72, Quantitative Finance Research Centre, University of Technology, Sydney.
    10. Hakansson, Nils H., 1971. "Capital Growth and the Mean-Variance Approach to Portfolio Selection," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 6(01), pages 517-557, January.
    11. Robert Fernholz & Ioannis Karatzas, 2005. "Relative arbitrage in volatility-stabilized markets," Annals of Finance, Springer, vol. 1(2), pages 149-177, November.
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    Cited by:

    1. Johannes Ruf, 2010. "Hedging under arbitrage," Papers 1003.4797, arXiv.org, revised May 2011.

    More about this item

    Keywords

    law of one price; law of the minimal price; derivative pricing; real world pricing; numeraire portfolio; growth optimal portfolio; strong arbitrage; extreme maturity bond;

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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