Monday, June 19, 2017

243. Only one price can exist on a market (operating under perfect market conditions) at any one time.

What is the 'Law Of One Price'

The law of one price is the economic theory that the price of a given security, commodity or asset has the same price when exchange rates are taken into consideration. The law of one price is another way of stating the concept of purchasing power parity. The law of one price exists because of the arbitrage opportunities that must be present and available.

BREAKING DOWN 'Law Of One Price'

If the price of a security, commodity or asset is different in two different markets, then an arbitrageur will purchases the asset in the cheaper market and sells it where prices are higher. Arbitrage profits will persist until the price converges across markets.

The law of one price eliminates the possibility of investors from taking advantage of a price disparity between markets because of the actions of arbitrageurs. If a particular security is available for $10 in Market A but is selling for the equivalent of $20 in Market B, investors could purchase the security on Market A and immediately sell it for $20 on Market B, netting a profit without any true risk or shifting of the markets. If the do so they will be acting as arbitrageurs and it is this very act that will drive prices up in Market A and drive prices down in market B. So, as securities bought from Market A are sold on Market B, prices on both markets shift in accordance with the changes in supply and demand. Over time, this would lead to a balancing of the two markets, returning the security to the state held by the law of one price.

In efficient markets, the occurrence of arbitrage opportunities are low, most often caused by an event causing a sudden shift occurring in one market before the other markets are effected. In these days of electronic trading - arbitrage trading, whilst still large, are trading on thinner and thinner margins.

Law of One Price and Commodities

When dealing in commodities, the cost to transport the goods must be included, resulting in different prices when commodities from two different locations are examined. If the difference is goes beyond the transportation costs, this can be a sign of a shortage or excess within a particular region.

Purchasing Power Parity

Purchasing power parity describes the effects controlled by the theory of the law of one price. It relates to a formula that can be applied to compare securities across markets that trade in different currencies. As exchange rates can shift frequently, the formula must be recalculated on a regular basis to ensure equality across the different international markets. The Law of One Expected Return

A continuation of the law of one price is the law of one expected return. This governs the idea that securities with similar asset prices and similar risks would be expected to generate similar returns.

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