law of one price

Law of One Price: What is it and How does it work?

The law of one price is nothing but a concept that revolves around the prices of an individual commodity or asset. In the law of one price, commodities available will have the same price at international levels, irrespective of the location. There are, somehow, certain factors that we need to take into consideration and hence, can get neutral values over the world. 

Or in general words: 

The LOOP, (Law of One Price) states that the price of different commodities in different markets must remain the same, taking into consideration the currency and hence, applying the currency changes into the act. This law is generally applied to the places where assets get traded in the financial markets.  

Let us have a look at these ‘certain factors’, 

As per the law of one price, we can say that some things must be looked at beforehand. Such things are as no transportation costs, or even no transaction costs. It is even ensured that the currency rates are the same and no manipulation of prices is done by the buyer or the seller. The other factors that one may consider are various such as competition at no cost as well as price flexibility. Various things that are bound to fall under the law are securities, assets, or various goods. 

The main reason behind the existence of this law is because of differences between various prices of commodities in diverse locations and it would eventually be removed due to the arbitrage opportunity. 

Here, arbitrage in simple terms means to purchase a commodity or asset from one place or a market at some price and then eventually selling the same thing at other market or place at a higher price.  

Hence, we can say that the law holds because of the arbitrage chances which get aroused. In general, you can think of a situation in such a way that a trader purchases a good in a market at some price lower, and then he is quick in selling the same in the other market over a comparatively high price. 

It is also interesting to note that the same theory is not very practical. It is not always correct. Sometimes, it may be possible that during a situation, it may get invalid due to a variety of factors involved. If you want an example, we can give you one! Assume a trade or a situation across the market where a variety of transportation as well as transaction costs takes place. In such situations, it is evident that the law will not hold true and hence, will not work. 

The LOOP is also considered as the base of PPP(Purchasing power parity). The so-called Purchasing Power Parity says that the two currency values get equalized when certain goods which are identical get the same price at both locations. Hence, the buyers have an equal amount of authority to buy things at both locations at similar prices. 

In the real world, the application of the Purchasing Power Parity is very difficult because of the various factors involved. Factors such as trading/transportation costs as well as it may be possible that a certain group of people may not be able to access both the markets in the same way. Hence, it plays a vital role in the non-application of Purchasing Power Parity. 

One other application of the same is that it is possible to check the pricing over various locations with the help of Purchasing Power Parity. Various markets that run on different currencies can get checked in terms of pricing. Though the currency prices at the international level face ups and downs frequently, and hence, with the help of Purchasing Power Parity, one can recalculate the same thing to check about mispricing at different places over the world.

Law of One Price over Financial Markets

law of one price

Source: etimg.com

It is generally believed that this law has a wider range of applications over the conventional international trading system. Experts and various economists have their say in a way that the LOOP has the most important dealing in the Financial Market

The primitive way this law can get executed in the Financial Market in such a way that no matter how the Financial Security had originated, Stock and bond options can be used to replicate a call option. Hence, the option call should be similar in terms of price to the portfolio that is replicated. 

Other aspects of the financial markets are Commodity. Commodities are one of the most vital examples of this law. Various types of Commodities get traded in various kinds of markets all over the world. 

Example of the law of one price:

If the price of any economic good or service is varying in two different markets, after considering the effects of currency exchange rates, then to earn a profit, an arbitrageur will purchase the asset in the low-priced market and sell it in the market where the prices of that same asset are higher. When this law holds, the arbitrage profits such as these will continue until the price converges across the markets. 

For instance, if a particular good is available for ₹1000 in market A but is selling for the corresponding of ₹2000 in market B, then investors could purchase the good from market A and immediately sell it for ₹2000 in market B, getting a profit of ₹1000 without any risk or shifting of the markets. 

As goods from market A are sold on market B, prices on both markets should change by the changes in supply and demand. Increased demand for these goods in market A, where it’s comparatively cheaper, should lead to an increase in its price there. 

Contrariwise, an increased supply in market B, where the good 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 harmonizing of the price of the good in these two markets, returning it to the condition suggested by this law.  

Violations of the Law of One Price

law of one price

Source: thebalance.com

As we already told you the real-life applications of the same are quite difficult to achieve. Hence, various factors that are involved get brushed off. This results in different prices over different locations and it will result in price variation over the places.

Also Read: Stock Trading Vs Stock Investing : Difference You Must Know

Transportation costs

When dealing with commodities, transportation costs are sort of inevitable. The cost to transport these tangible assets must be calculated which often leads to different rates of commodities, as both of these commodities albeit them being identical, are produced by two different manufacturers and are transported from various regions. 

For instance, tea transported from Assam to Gujarat and the same product transported from Wayanad, of course, will have deviations in their prices. They will have different transportation costs, which will result in different rates of tea, resulting in the violation of this law.  

Transaction costs 

As transaction costs exist and can fluctuate with different markets of different geographical locations, prices for the same product can vary in different markets. Where transaction costs, such as the costs to find a suitable trading adverse party or costs to impose or negotiate a contract are higher, the prices of goods in this market will be higher than those of those who have lower transaction costs. This will result in deviations in the commodity’s price, hence resulting in the violation of this law. 

Legal restrictions 

Various factors that get involved in the legal restriction are such as Tariffs and other capital controls. The effect observed here is similar to the one of transportation as well as transaction ones. If we are tending to take an example, one can understand the concept as follows. If tariff has been imposed by the country on importing of a good, then the prices in the local area would tend to be higher than the world level prices. 

Market Structure

We know that the buyers and sellers have various proportional ratio and hence, because of various buyers and sellers, and their ability in the modification of things vary from market to market, the ability to set up the prices of the goods can vary as well.

Easily available goods who have negligible transportation costs can also have different prices over different places due to the monopoly of a seller who wants to enjoy a high market power degree. 

This was all about the Law of One Price. We hope that you have understood the concept well and other various factors involved. The concept is simple to understand but has a wide range of applications in various areas. We hope that the article has served its purpose and has enlightened you in terms of this concept. 

For more finance-related concepts you can have a look at the FinanceShed, and stay tuned for more updates.