The law of one price is a fundamental concept of finance theory. Consider two sets of future cash flows. These can be fixed (as in cash flows from Treasury bills) and/or contingent (as in cash flows from options). Although they are identical, suppose the respective sets of cash flows are constructed differently—each achieved with different financial instruments. So long as those financial instruments do not differ with respect to factors such as tax treatment, liquidity, credit risk, transaction costs, etc., the two sets of cash flows must have the same market value. The law of one price states that there must be a single price that applies to both sets of cash flows in the market. Put-call parity illustrates the law of one price. A call option can be replicated with a static portfolio comprising
Because of the law of one price, put-call parity requires that the call option and the replicating portfolio must have the same price. Interest rate parity, which plays an important role in the foreign exchange markets, is another example of the law of one price. Any violation of the law of one price is an arbitrage opportunity. A common mistake traders make is to forget the caveat that the price discrepancy should not arise from factors such as tax treatment, liquidity or credit risk. They will put on what they perceive to be an arbitrage when in fact there is no violation of the law of one price. The law of one price underlies the important financial engineering concept of arbitrage-free pricing.
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