The Law of One Price Essay

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The “Law of One Price”, as described by Isard (1977), appears to be empirically invalid, yet there are conflicting evidences such as gold prices as at 24 February 1995 (Rogoff, 1996), suggest that the Law seems to hold true. This essay shall evaluate the argument using both theories and empirical evidences related to Law of One Price and Purchasing power parity (hereafter PPP). In essence, Law of One Price (hereafter LOOP) states that “the price of identical goods that are traded is the same in all geographical locations” (Persson, 2010, p. 221). To begin the investigation, preliminary observations can be made using market information with the Eurozone where the same currency is used within the currency union. Consequently, effect on…show more content…
Firstly, in the absence of vital pricing information, some price differences are not corrected as investors are simply not aware of the variances and, as a result of the absence of arbitrage trades, the differences remain unadjusted. Moreover, some market information is often not up-to-date. (Jensen, 2007) It is arguably true that investors can rely on out-dated market information to invest accordingly and still achieve profit. However, this is a potentially risky investment because simultaneous transactions may be hindered. By the time the arbitrage transactions are completed, commodity prices may have already been moved against the investors’ will. By definition, arbitrages are risk-free. (LeRoy & Werner, 2001) Thus, transactions described above are irrelevant to the fundamental maintenance of LOOP. Therefore, for arbitrageurs to take advantage of pricing differences and to maintain LOOP, they must be well-informed of the mispricing. Next, in the absence of an ultimate profit, investors may not be interested in arbitrage opportunities, which subsequently correct the pricing differences and restore LOOP. For instance, transaction cost may prohibit arbitrage. Even in the assumption of the absence of transport cost and trade restrictions, if all the total associated transaction cost is higher than the profit from the arbitrage, it is highly unlikely that rational investors will participate in arbitraging activities
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