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

Abstract

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.