What is the Law of One Price?
The Law of One Price (LOOP) is an economic theory that suggests that after accounting for the difference in currency exchange rates, the prices of identical goods in various markets will be the same. This law applies to financial markets and the securities traded on them. However, it makes some assumptions, which must be true for it to work.
The law of one price depends on various principles. These include free-market competition, price stability, and lack of trade restrictions. In an efficient market, the law of one price will always apply. It also provides the basis for the purchasing power parity principle in economics.
How does the Law of One Price work?
The law of one price works in an efficient market, where no legal restrictions, transactions costs, or transportation costs exist. Similarly, it assumes that the currency exchange rates are the same. Lastly, it works on the basis that buyers or sellers cannot manipulate prices in various markets. This law applies to a wide range of securities.
The law of one price exists due to arbitrage opportunities. When security prices differ across various markets, investors can profit from buying in the market with lower rates and selling in higher rate markets. For those securities, an arbitrage opportunity exists. However, due to the exploitation of these opportunities, the securities’ prices would reach an equilibrium.
Without the law of one price, the concept of purchasing power parity is not achievable. The law of one price states that the price of securities would remain the same in different markets. It is one of the crucial assumptions made for the purchasing power parity. However, because security prices may differ in various markets or due to investors’ inability to access markets, it may not apply.
The law of one price is prevalent in financial markets. Due to the lower trade barriers and the high regulations that apply in these markets, this law is more applicable. The law of one price also works best with commodities. These prices remain similar throughout various markets. Therefore, commodities conserve the law of one price.
What are the limitations of the Law of One Price?
The primary limitations of the law of one price come from its assumptions. As mentioned, the law of one price makes several assumptions, which may not always apply. Firstly, it assumes that there are no transportation costs. If the difference between commodity prices does not come due to transportation costs, it may signify a shortage or excess within a region.
Similarly, the law assumes that there are no transaction costs. In the real world, however, transaction costs exist for all assets and securities. Likewise, the law of one price does not consider the legal restrictions between various countries or markets. However, these can have a similar impact on prices as transaction and transportation costs.
The law of one price is a theory in economics. It suggests that the prices of identical goods across various markets will remain the same after considering the difference in forex exchange rates. This law is more prevalent in the financial markets than for other goods or services. The law of one price makes several assumptions, which can result in some limitations.