The Law of One Price and Arbitrage The law of one price is enforced by a process called arbitrage Arbitrage is the purchasing of a set of assets,and immediate sale of another set of assets,in such a way as to earn a sure profit from price differences THE COURSE OF FINANCE 2017 SPRING SJTU 11
The Law of One Price and Arbitrage The law of one price is enforced by a process called arbitrage Arbitrage is the purchasing of a set of assets, and immediate sale of another set of assets, in such a way as to earn a sure profit from price differences THE COURSE OF FINANCE 2017 SPRING SJTU 11
The Law of One Price and Arbitrage Arbitrageurs engage in the business of trading similar assets with a price differential that cannot be justified by transaction-and transformation-costs Example:Gold in any two parts of the country should not differ by more than the transaction costs of moving it THE COURSE OF FINANCE 2017 SPRING SJTU 12
The Law of One Price and Arbitrage Arbitrageurs engage in the business of trading similar assets with a price differential that cannot be justified by transaction- and transformation-costs Example: Gold in any two parts of the country should not differ by more than the transaction costs of moving it THE COURSE OF FINANCE 2017 SPRING SJTU 12
7.4 Arbitrage and the Prices of Financial Assets Arbitraging by shipping a physical commodity(gold) involves higher transaction costs than arbitraging financial assets (shares of stock) We expect the same financial commodity trading on two markets to be priced very closely THE COURSE OF FINANCE 2017 SPRING SJTU 13
7.4 Arbitrage and the Prices of Financial Assets Arbitraging by shipping a physical commodity (gold) involves higher transaction costs than arbitraging financial assets (shares of stock) We expect the same financial commodity trading on two markets to be priced very closely THE COURSE OF FINANCE 2017 SPRING SJTU 13
Arbitrage and the Prices of Financial Assets The rule of one price is the most fundamental valuation principle in finance. If two very similar securities trade at significantly different prices,we first suspect Interference with normal market operation Some unrecognized difference between the two assets THE COURSE OF FINANCE 2017 SPRING SJTU 14
Arbitrage and the Prices of Financial Assets The rule of one price is the most fundamental valuation principle in finance. If two very similar securities trade at significantly different prices, we first suspect Interference with normal market operation Some unrecognized difference between the two assets THE COURSE OF FINANCE 2017 SPRING SJTU 14
Arbitrage and the Prices of Financial Assets No two non-identical assets are exactly alike,and there may be occasions when two similar assets trade at different prices Dollar bills with certain serial numbers are very valuable to players of liar's poker Not even a dollar is always worth a dollar! THE COURSE OF FINANCE 2017 SPRING SJTU 15
Arbitrage and the Prices of Financial Assets No two non-identical assets are exactly alike, and there may be occasions when two similar assets trade at different prices Dollar bills with certain serial numbers are very valuable to players of liar’s poker Not even a dollar is always worth a dollar! THE COURSE OF FINANCE 2017 SPRING SJTU 15