Question

1. How does the law of one price work? What happens if this law is violated?

Answer 1

The one price rule is an economic concept which states that if certain factors are considered, the value of an equivalent asset or commodity will have the same global price regardless of location. Single price law takes a frictionless market into account, where there are no transaction costs, transportation costs, or legal restrictions, the currency exchange rates are the same, and buyers or sellers do not manipulate prices. One price law exists as discrepancies between asset prices at different locations will ultimately be reduced due to the ability of arbitration.

In reality, parity of purchasing power is difficult to achieve due to different trading costs and the inability of some individuals to access markets. The purchasing power parity formula is useful in that it can be used to compare prices that trade in different currencies across markets. As exchange rates can shift frequently, it is possible to recalculate the formula on a regular basis to identify mispricing across different international markets

To see a very large relative price difference in this market — where you have securities that can accurately mimic other securities ' cash flows in the same market and all have the same credit risk — this is just a very clear violation of what economists call the ' one-price rule ' whereby two portfolios that have the same assured or certain cash flows should be priced identically..