Question

What is the law of one price? What is arbitrage?

Short answer

The Law of One Price is an economic theory that states an identical good should cost the same across all markets when prices are expressed in a common currency, assuming no trade restrictions or transaction costs. Arbitrage is the practice of profiting from price differences of an identical good in different markets. The Law of One Price holds true in an absence of arbitrage opportunities.

Step-by-step solution

Defining the Law of One Price

The law of one price refers to the economic theory that states the price of an identical good or asset must have the same price globally regardless of the country, when prices are expressed in a common currency. This is under the assumption that there are no trade restrictions or transaction costs.

Defining Arbitrage

Arbitrage, in the context of economics and finance, is the practice of capitalizing on the price differences of an identical good or asset across different markets. Traders who practice arbitrage look to purchase a good or asset at a lower price in one market and then sell it at a higher price in another thereby making a profit without any risk or net cash investment.

Explaining the Relation between the Law of One Price and Arbitrage

These two concepts are related because the existence of arbitrage opportunities violates the law of one price. In other words, if the law of one price holds true, then there should be no arbitrage opportunities. When such opportunities arise, traders take advantage of the price differences affecting the demand and supply, which eventually leads to price equality or the law of one price.

Key concepts

Arbitrage

Arbitrage is an essential concept in both economics and finance that involves taking advantage of price differences for the same asset or good in different markets. Imagine you find an identical product being sold cheaper in one market compared to another. By purchasing the product in the lower-price market and immediately selling it in the higher-price market, you can earn a profit with minimal risk. This process is known as arbitrage. Key characteristics of arbitrage include:

• Risk-Free Profit: The goal is to achieve a profit without exposure to financial risk.
• No Net Investment: Typically requires no net expenditure since the buying and selling happen simultaneously.
• Market Efficient: Arbitrage helps correct price inefficiencies across different markets.

Understanding arbitrage underscores the interconnectedness of global markets and highlights how traders can contribute to market efficiency by exploiting price discrepancies.

Economic Theory

Economic theory is a broad concept that provides frameworks for understanding how economies function and how agents interact within these economies. It encompasses the law of one price which plays a crucial role in understanding market equilibrium. According to this law, the price of an identical asset should be the same globally, when expressed in a common currency, assuming no external barriers like tariffs or transportation costs. Economic theory helps illuminate how:

• Prices are Equalized: It suggests that market forces such as supply and demand push towards a state where prices are uniform across different regions.
• Efficiencies Occur: Markets tend towards efficiency when resources are optimally distributed based on prices.
• Trade Without Friction: Ideally assumes perfect conditions where trade is free from friction or obstacles.

Understanding these principles of economic theory assists in grasping more complex global economic and financial interactions.

Price Differences

Price differences occur when the same goods or services are sold at varying prices in different locations or markets. These differences can be due to several factors like transportation costs, tariffs, exchange rates, or even local supply and demand variations. Price differences provide the foundation for arbitrage opportunities, allowing traders to buy low in one market and sell high in another. Factors leading to price differences include:

• Transaction Costs: Costs involved in buying, selling, and shipping goods can result in varying prices.
• Supply and Demand: Varying levels of supply and demand in local markets impact pricing.
• Currency Fluctuations: Changes in exchange rates affect the price of internationally traded goods.

Price differences are essential for marketers and economists as they reflect the dynamic nature of market conditions and the interplay of various economic factors.

Market Efficiency

Market efficiency is a concept that describes how well market prices reflect all available information. In an efficient market, assets are priced accurately according to their intrinsic value, and any deviations are quickly corrected by market participants. The exploitation of arbitrage opportunities plays a significant role in enhancing market efficiency by ensuring that price discrepancies are minimized. Factors enhancing market efficiency include:

• Information Dissemination: Quick and wide dissemination of relevant information helps in making well-informed market decisions.
• Active Trading: Continuous trading by investors leads to more accurate pricing.
• Regulatory Framework: Proper regulations ensure fair and efficient market practices.

Understanding market efficiency helps students and practitioners appreciate the mechanisms through which financial markets operate and the crucial role of information in determining asset prices.