What is Rational Pricing
Rational pricing is the assumption in financial economics that prices of assets (including within asset pricing models) will represent the arbitrage-free pricing level for those assets. It is expected that any deviation from arbitrage-free price levels for such assets will result in arbitrageurs immediately trading away the profit opportunity on the asset until it trades at an arbitrage-free price. Rational pricing assumptions are typically applied to fixed income securities which have common attributes such as maturity and yield that allow “apples to apples” comparison of two similar securities. Rational pricing is also used with derivatives as pricing moves predictably based on the underlying asset or group of assets.
BREAKING DOWN Rational Pricing
A typical example of where the theory of rational pricing would be expected to come into play would be two identical assets trading in different markets. If the asset traded at a lower price in one market, an arbitrage trader could attempt to make a risk-free profit by making a purchase of the asset in the cheaper market, and by immediately selling the asset in the more expensive market. With enough volume, this arbitrage trading would soon cause the prices in both markets to converge to an equal value, removing the arbitrage opportunity.
In order for arbitrage trading to be successful, there needs to be a wide enough gap in prices that trading costs and bid-ask spreads are covered. In the contemporary world of high-speed electronic trading, bid-ask spreads have become much tighter, and information from different exchanges or market makers is transmitted so rapidly that market prices, (as opposed to limit orders priced above or below the market) tend to be consistent, making simple price arbitrage difficult.