Law of One Price

Overview

The law of one price is idea that is used in no arbitrage pricing frameworks to create pricing models. This is typically most useful for pricing of derivative products.

The law of one price states that two instruments that have the exact same payoffs, should have the same price. It is important to make the distinction that the instruments have exactly the same payoffs, any deviation from exact will mean that the prices can vary.

The logic behind the principle is that if two instruments have the same payoffs, one could make arbitrage profits by buying one and selling the other short.

When the payoffs of two instruments are not exactly the same, but at least statistically close, it can often be used to justify similar prices. In particular, one can build a relative valuation model by focusing on the differences between the instruments.