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 due to arbitrage opportunities.
BREAKING DOWN 'Law Of One Price'If the price of a security, commodity or asset is different in two different markets, then an arbitrageur purchases the asset in the cheaper market and sells it where prices are higher. When the purchasing power parity doesn't hold, arbitrage profits will persist until the price converges across markets.
The law of one price is in place to prevent investors from taking advantage of a price disparity between markets in a situation known as arbitrage. 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.
As securities 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.
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.