As part of your effort to understand the process of evaluating various elements
ID: 2733756 • Letter: A
Question
As part of your effort to understand the process of evaluating various elements of the financial marketplace, your Financial Manager states that it may become important to take advantage of arbitrage opportunities. You have been studying this aspect of the financial marketplace and would like to review your understanding. Describe what the term “arbitrage” means in the financial context; give an example of “arbitrage opportunity” and then discuss how the “law of one price” would impact these opportunities.
Explanation / Answer
Arbitrage is the simultaneous purchase and sale of an asset in order to profit from a difference in the price. It is a trade that profits by exploiting price differences of identical or similar financial instruments, on different markets or in different forms. Arbitrage exists as a result of market inefficiencies; it provides a mechanism to ensure prices do not deviate substantially from fair value for long periods of time.
This is considered riskless profit for the investor/trader.
Exploiting a vulnerability to arbitrage of the particular commodity by an investor or trader is known as arbitrage opportunity. Here is an example of an arbitrage opportunity. Let's say you are able to buy a toy doll for $15 in Tallahassee, Florida, but in Seattle, Washington, the doll is selling for $25. If you are able to buy the doll in Florida and sell it in the Seattle market, you can profit from the difference without any risk because the higher price of the doll in Seattle is guaranteed.
The law of one price is the theory that the price of a given security, commodity or asset will have the same price when exchange rates are taken into consideration. The law of one price is another way of stating the concept of purchasing power parity.
The law of one price exists due to arbitrage opportunities. If the price of a security, commodity or asset is different in two different markets, then an arbitrageur will purchase the asset in the cheaper market and sell it where prices are higher.
When the purchasing power parity doesn't hold, arbitrage profits will persist until the price converges across markets.
Hence, with the above explanation it is clear that Law of one price or purchasing power parity theory prevents the scope of arbitrage. Thus it can be said that, law of on price has an adverse impact on arbitrage opportunities.
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