The law of one price in quadratic hedging and mean-variance portfolio selection
The 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 selection framework without degeneracy. Crucially, the paper identifies a new mecha...
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Zusammenfassung: | The 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 selection
framework without degeneracy. Crucially, the paper identifies a new mechanism
through which LOP can fail in a continuous-time $L^2$ 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 claims in an extended market
and subsequently plays an important role in quadratic hedging and mean-variance
portfolio selection.
Mathematically, we formulate a novel variant of the uniform boundedness
principle for conditionally linear functionals on the $L^0$ module of
conditionally square-integrable random variables. We then study the
representation of time-consistent families of such functionals in terms of
stochastic exponentials of a fixed local martingale. |
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DOI: | 10.48550/arxiv.2210.15613 |