What is Law of One Price?
Law of one price is a financial law which states that the price of same (identical) instruments must be same at a given time in an efficient market. The law applies to most financial instruments available for trading/investing as commodities, equities, derivatives and funds. Example: the price of one commodity or equity traded in two different exchanges must be same at a point of time.
Whenever a violation from law of one price occurs, it creates an arbitrage opportunity. The arbitrator will purchase the instrument from cheaper market and will simultaneously sell those in market with high price. The process continues until the prices converge. The basic idea of law of one price is that as no trader will sell instruments below the market maker’s offer level and no trader will buy above market maker’s bid level, the prices will stay same (with in a range).
Law of one price does not apply to instruments when 1) they are non-tradable instruments, 2) they are traded at different time frames, and 3) traded in inefficient markets – i.e., when traders are unaware of exact market prices. Two good examples of Law of one price are Put-Call parity – the relationship exists between call and put options, and Interest rate parity – relationship between interest rate of two currencies.
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Whenever a violation from law of one price occurs, it creates an arbitrage opportunity. The arbitrator will purchase the instrument from cheaper market and will simultaneously sell those in market with high price. The process continues until the prices converge. The basic idea of law of one price is that as no trader will sell instruments below the market maker’s offer level and no trader will buy above market maker’s bid level, the prices will stay same (with in a range).
Law of one price does not apply to instruments when 1) they are non-tradable instruments, 2) they are traded at different time frames, and 3) traded in inefficient markets – i.e., when traders are unaware of exact market prices. Two good examples of Law of one price are Put-Call parity – the relationship exists between call and put options, and Interest rate parity – relationship between interest rate of two currencies.
NobleTrading.com Offers Online Stock Trading, Online Options Trading
Online Futures Trading, Online Forex Trading
Worldwide Brokerage Service, Day Trading Brokerage
posted by NobleTrading at
9:06 AM
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