What is the Law of One Price (LOOP)?
The Law of One Price (sometimes referred to as LOOP) is an economic theory that states that the price of identical goods in different markets must be the same after taking the currency exchange into consideration (i.e., if the prices are expressed in the same currency). The law principally applies to assets traded in financial markets.
Understanding the Law of One Price
The Law of One Price is based on several assumptions, which include free competition in the markets, the absence of trade restrictions, and price flexibility (i.e., neither sellers nor buyers can manipulate the prices of the goods, and prices are adjusted freely). The law of one price is generally applicable to a wide range of goods, securities, and assets.
The LOOP primarily holds due to arbitrage opportunities. If the prices of identical goods diverge from each other across the markets, arbitrage opportunities arise since a trader may purchase a good in a market at a lower price and immediately sell it in another market at a higher price for a net profit. Economic theory states that subsequently, the forces of supply and demand will converge the prices across the markets and, therefore, the arbitrage opportunities will be eliminated.
However, in practice, the law of one price does not always hold true. For example, if the trade of goods involves transaction costs or trade barriers, the law will not work.
The Law of One Price in Financial Markets
The law of one price generally holds in financial markets. Economists believe that the LOOP is more strongly applicable in financial markets than in international trade since there are fewer potential trade barriers in the former.
In financial markets, the primary implication of the LOOP is that a financial security must come with a single price regardless of how the security was created. For example, a call option can be replicated using a stock and bond. The LOOP states that the price of a call option must be equal to the price of the replicated portfolio.
Commodities remain the most notable example of the law of one price in financial markets. Commodities are traded across various markets in the world using a variety of financial instruments, typically forwards or futures. Nonetheless, commodity prices are typically homogeneous across the markets due to the LOOP.
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