What is the Law Of One Price
The law of one price is the economic theory that states the price of an identical security, commodity or asset traded anywhere should have the same price regardless of location when currency exchange rates are taken into consideration, if it is traded in a free market with no trade restrictions. The law of one price exists because differences between asset prices in different locations should eventually be eliminated due to the arbitrage opportunity.
BREAKING DOWN Law Of One Price
The law of one price theory is the underpinning of the concept of purchasing power parity. Purchasing power parity states that the value of two currencies is equal when a basket of identical goods is priced the same in both countries. 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 can be recalculated on a regular basis to identify mispricings across various international markets.
Example of the Law of One Price
If the price of a security, commodity or asset is different in two different free markets after considering the effects of currency exchange rates, then an arbitrageur could purchase the asset in the cheaper market and sell it in the market where prices are higher to earn a profit. When the law of one price does not hold, arbitrage profits such as these will persist until the price converges across markets. For example, 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 should change in accordance with the changes in supply and demand, all else equal. Increased demand for the security in Market A, where it is relatively cheaper, should lead to an increase in its price there.
Conversely, increased supply in Market B, where the security is being sold for a profit by the arbitrageur, should lead to a decrease in its price there. Over time, this would lead to a balancing of the price of the security in the two markets, returning it to the state suggested by the law of one price.
In efficient markets, the occurrence of arbitrage opportunities such as these are low, and most often caused by an event that results in a sudden shift in one market before the other markets are affected. 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.
Law of One Price and Commodities
When dealing in commodities, the cost to transport them must be included, resulting in different prices when commodities from two different locations are examined. If the difference in transportation costs does not account for the difference in commodity prices between regions, it can be a sign of a shortage or excess within a particular region.