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.

  1. Rationalization

    Rationalization is a reorganization of a company in order to ...
  2. Forex Arbitrage

    Forex arbitrage is the simultaneous purchase and sale of currency ...
  3. Rational Choice Theory

    Rational choice theory is an economic principle that assumes ...
  4. Arbitrage Trading Program (ATP)

    An arbitrage trading program (ATP) is a computer program that ...
  5. Rational Expectations Theory

    The rational expectations theory posits that individuals make ...
  6. Time Arbitrage

    Time arbitrage refers to an opportunity created when a stock ...
Related Articles
  1. Trading

    Why Is Arbitrage Trading Legal?

    Not only is arbitrage legal in the US and most developed countries, it can be beneficial to the overall health of a market.
  2. Investing

    How Precious Metals Like Gold Can Be Arbitraged

    Arbitrage trading involves a lot of risk and can get challenging. Find out how to benefit from the price differential between the buy and sell price.
  3. Investing

    How Statistical Arbitrage Can Lead to Big Profits

    Statistical arbitrage is one of the most influential trading strategies ever devised. Learn how it is leveraged by investors and traders seeking profits.
  4. Trading

    Make Money Through Risk Arbitrage Trading

    Risk arbitrage provides a valuable trading strategy for merger and acquisition or other corporate actions eligible stocks.
  5. Investing

    3 Mutual Funds Focusing on Arbitrage Profits (MERFX, ARBFX)

    Get details on three of the most popular mutual funds for investors interested in arbitrage trading.
  6. Investing

    The Fast-Paced World of Libor & Fixed Income Arbitrage

    LIBOR is an essential part of implementing the swap spread arbitrage strategy for fixed income arbitrage. Here is a step-by-step explanation of how it works.
  7. Investing

    Hedge Funds Hunt for Upside, Regardless of Market

    Hedge funds seek positive absolute returns through aggressive strategies to make this happen.
  8. Personal Finance

    What Are the Risks of Credit Card Arbitrage?

    Find out why credit card arbitrage is a major gamble with devastating risks for those trying to beat the credit card companies at their own rate game.
  9. Investing

    How To Calculate The Bid-Ask Spread

    It's very important for every investor to learn how to calculate the bid-ask spread and factor this figure when making investment decisions.
  1. Why do futures' prices converge upon spot prices during the delivery month?

    Learn why as the delivery month of a futures contract approaches, the future's spot price will generally inch toward or even ... Read Answer >>
  2. When is a buy limit order executed?

    A buy limit order is only executed when the asking price is at or below the limit price specified in the order. Read Answer >>
  3. How do you account for changes in the market value of various fixed assets?

    Understand how to account for changes in the fair market value of a company's fixed assets. Learn what accounting methods ... Read Answer >>
  4. What is the difference between carrying value and market value?

    Understand the difference between carrying value and market value. Learn when a company uses carrying value to value an asset ... Read Answer >>
Trading Center