The Law of One Price states that identical goods should have the same price globally. It encompasses characteristics like uniform quality, absence of arbitrage opportunities, and market efficiency. It explains price alignment through market integration and arbitrage. The law applies to commodities, financial assets, and forex trading, with violations stemming from transportation costs and trade barriers.
Law of One Price (LOP) is an economic principle that states that identical goods or assets should sell for the same price when expressed in a common currency, considering no transportation costs and no differential taxes applied in different locations.
The LOP is fundamental in the field of international trade, finance, and arbitrage, as it provides the basis for understanding how prices should be equalized across markets.
Key Concepts and Components
Identical Goods or Assets:
The LOP applies to goods or assets that are considered identical in all relevant aspects, including quality, quantity, and specifications. This principle does not apply to goods with different characteristics.
Common Currency:
Prices must be expressed in the same currency to apply the LOP. This allows for a direct comparison of prices across different markets.
Absence of Transportation Costs:
The LOP assumes that there are no transportation costs involved in moving goods from one market to another. In reality, transportation costs can affect price disparities.
Absence of Taxes and Tariffs:
Differential taxes or tariffs can impact prices and create deviations from the LOP. The principle assumes that there are no such taxes or tariffs.
Arbitrage and the LOP
Arbitrage:
Arbitrage is the process of exploiting price differences for the same asset in different markets. When a price differential exists between two markets, arbitrageurs buy in the lower-priced market and sell in the higher-priced market to profit from the price gap.
Enforcement of the LOP:
Arbitrage activities help enforce the LOP by pushing prices toward equality. If prices deviate from the LOP, arbitrageurs enter the market, buying or selling the asset until prices converge.
Violations and Factors Affecting the LOP
Transaction Costs:
Transaction costs, such as brokerage fees or exchange costs, can hinder arbitrage activities, leading to temporary price disparities.
Transportation and Shipping Costs:
Physical goods may incur transportation and shipping costs, which can create discrepancies in prices across locations.
Differential Taxes and Tariffs:
Taxation policies and tariffs can lead to price variations that violate the LOP. Governments may impose taxes or tariffs on specific goods, affecting their prices.
Information Asymmetry:
Information disparities between markets, such as differences in market knowledge or access to information, can lead to LOP violations.
Use Cases of the LOP
International Trade:
The LOP is crucial in international trade theory. It suggests that in the absence of transportation costs and trade barriers, identical goods should have the same price in different countries when expressed in a common currency.
Financial Markets:
In financial markets, the LOP is used to assess the value of assets, such as stocks and commodities, in different markets. Price disparities can trigger trading activities to equalize prices.
Challenges and Limitations
Real-World Factors:
In practice, various real-world factors, such as transportation costs, taxes, tariffs, and market imperfections, can prevent the strict application of the LOP.
Market Frictions:
Market frictions, including transaction costs and information disparities, can hinder the ability of arbitrageurs to quickly equalize prices.
Empirical Evidence
Empirical Studies:
Economists conduct empirical studies to test the LOP in various markets. These studies examine price differentials, transaction costs, and other factors that affect the degree to which the LOP holds.
Deviation from LOP:
In practice, price disparities exist due to factors like transportation costs, taxes, and information asymmetry. However, the LOP serves as a benchmark for evaluating market efficiency.
Key Highlights
Economic Principle: The Law of One Price is a fundamental economic principle that asserts that identical goods should have the same price in various markets.
Characteristics:
Identical Goods: The law applies to goods with uniform quality, attributes, and characteristics across different markets.
No Price Arbitrage: The absence of opportunities for risk-free profit due to price disparities prevents arbitrage.
Market Integration: The concept is explained by the alignment of prices through market integration, where interconnected markets influence each other’s prices.
Arbitrage: The possibility of arbitrage, exploiting price differences between markets, further clarifies the law’s principles.
Applications:
Commodity Markets: The law is evident in global commodity markets, where identical commodities like oil and precious metals exhibit convergence in prices due to market integration.
Financial Assets: Financial instruments such as currency exchange rates and interest rates align across markets in accordance with the law.
Violations:
Transportation Costs: Transportation expenses impact price disparities, as they add to the cost and affect the uniformity of prices across markets.
Trade Barriers: Tariffs, regulations, and trade barriers can lead to deviations from the law, causing variations in prices between markets.
Use Cases:
Commodity Prices: Integrated markets lead to commodity price convergence. For instance, oil prices tend to align globally due to market integration.
Forex Trading: In foreign exchange trading, efficient forex markets ensure that exchange rates align according to the Law of One Price.
Examples:
Big Mac Index: The “Big Mac Index” is a lighthearted illustration of the law, using McDonald’s Big Mac as a benchmark to compare purchasing power parity between countries.
Arbitrage Opportunities: Instances of price differences between markets present opportunities for arbitrage, reinforcing the law’s principles.
Related Frameworks
Description
When to Apply
Purchasing Power Parity (PPP)
– A theory that suggests that in the absence of transaction costs and barriers to trade, identical goods should have the same price when expressed in a common currency. Purchasing Power Parity (PPP) is used to compare the relative value of currencies and assess whether exchange rates are in equilibrium.
– When analyzing international trade and investment opportunities. – Applying Purchasing Power Parity (PPP) to forecast exchange rate movements, assess currency valuation, and identify arbitrage opportunities effectively.
The Big Mac Index
– An informal measure of purchasing power parity that compares the price of a Big Mac hamburger across different countries. The Big Mac Index is used as a simple and intuitive way to assess whether currencies are overvalued or undervalued relative to the US dollar.
– When analyzing international currency exchange rates and assessing relative price levels. – Using The Big Mac Index to gauge currency valuation, identify discrepancies in purchasing power, and inform investment decisions effectively.
Law of Price
– A principle that states that in a competitive market, the price of a good or service will tend to equal its marginal cost of production in the long run. The Law of Price ensures that prices are determined by supply and demand dynamics and reflects the underlying costs of production.
– When analyzing market structures and pricing dynamics in competitive industries. – Applying the Law of Price to understand pricing mechanisms, predict market outcomes, and assess market efficiency effectively.
Law of Demand
– A fundamental economic principle that states that as the price of a good or service increases, the quantity demanded decreases, and vice versa, assuming all other factors remain constant. The Law of Demand describes the inverse relationship between price and quantity demanded.
– When analyzing consumer behavior and pricing strategies. – Leveraging the Law of Demand to forecast demand changes, optimize pricing decisions, and develop effective marketing strategies effectively.
Law of Supply
– A fundamental economic principle that states that as the price of a good or service increases, the quantity supplied increases, and vice versa, assuming all other factors remain constant. The Law of Supply describes the direct relationship between price and quantity supplied.
– When analyzing producer behavior and market dynamics. – Applying the Law of Supply to predict supply responses to price changes, assess production costs, and optimize resource allocation effectively.
The Fisher Equation
– An economic formula that expresses the relationship between nominal and real interest rates, inflation rates, and expected returns on investment. The Fisher Equation helps investors understand the relationship between nominal interest rates, inflation expectations, and real purchasing power.
– When analyzing interest rate movements and inflation expectations. – Using The Fisher Equation to calculate real interest rates, adjust investment strategies, and make informed financial decisions effectively.
Balassa-Samuelson Effect
– A theory that suggests that differences in productivity growth between countries lead to differences in real exchange rates and price levels. The Balassa-Samuelson Effect explains why prices tend to be higher in countries with higher productivity levels.
– When analyzing international trade patterns and exchange rate movements. – Applying the Balassa-Samuelson Effect to understand the drivers of exchange rate disparities, assess trade competitiveness, and inform macroeconomic policies effectively.
Absolute Purchasing Power Parity
– A version of the Purchasing Power Parity theory that suggests that in the absence of transportation costs and trade barriers, the exchange rate between two currencies should equal the ratio of the price levels in the two countries. Absolute Purchasing Power Parity implies that identical goods should have the same price when expressed in different currencies.
– When analyzing international trade and investment opportunities. – Using Absolute Purchasing Power Parity to assess currency valuation, forecast exchange rate movements, and identify arbitrage opportunities effectively.
Relative Purchasing Power Parity
– A version of the Purchasing Power Parity theory that suggests that changes in exchange rates between two currencies should reflect changes in the relative price levels in the two countries. Relative Purchasing Power Parity implies that changes in exchange rates should offset differences in inflation rates between countries.
– When analyzing international trade flows and currency exchange rate movements. – Applying Relative Purchasing Power Parity to assess currency valuation, hedge against inflation risk, and manage currency exposure effectively.
Interest Rate Parity
– A theory that suggests that the difference in interest rates between two countries is equal to the expected change in exchange rates between their currencies. Interest Rate Parity helps investors understand the relationship between interest rates and exchange rates and assess arbitrage opportunities in currency markets.
– When analyzing currency exchange rate movements and interest rate differentials. – Leveraging Interest Rate Parity to forecast exchange rate changes, evaluate currency risk, and optimize investment strategies effectively.
The circle of competence describes a person’s natural competence in an area that matches their skills and abilities. Beyond this imaginary circle are skills and abilities that a person is naturally less competent at. The concept was popularised by Warren Buffett, who argued that investors should only invest in companies they know and understand. However, the circle of competence applies to any topic and indeed any individual.
Economic or market moats represent the long-term business defensibility. Or how long a business can retain its competitive advantage in the marketplace over the years. Warren Buffet who popularized the term “moat” referred to it as a share of mind, opposite to market share, as such it is the characteristic that all valuable brands have.
The Buffet Indicator is a measure of the total value of all publicly-traded stocks in a country divided by that country’s GDP. It’s a measure and ratio to evaluate whether a market is undervalued or overvalued. It’s one of Warren Buffet’s favorite measures as a warning that financial markets might be overvalued and riskier.
Venture capital is a form of investing skewed toward high-risk bets, that are likely to fail. Therefore venture capitalists look for higher returns. Indeed, venture capital is based on the power law, or the law for which a small number of bets will pay off big time for the larger numbers of low-return or investments that will go to zero. That is the whole premise of venture capital.
Foreign direct investment occurs when an individual or business purchases an interest of 10% or more in a company that operates in a different country. According to the International Monetary Fund (IMF), this percentage implies that the investor can influence or participate in the management of an enterprise. When the interest is less than 10%, on the other hand, the IMF simply defines it as a security that is part of a stock portfolio. Foreign direct investment (FDI), therefore, involves the purchase of an interest in a company by an entity that is located in another country.
Micro-investing is the process of investing small amounts of money regularly. The process of micro-investing involves small and sometimes irregular investments where the individual can set up recurring payments or invest a lump sum as cash becomes available.
Meme stocks are securities that go viral online and attract the attention of the younger generation of retail investors. Meme investing, therefore, is a bottom-up, community-driven approach to investing that positions itself as the antonym to Wall Street investing. Also, meme investing often looks at attractive opportunities with lower liquidity that might be easier to overtake, thus enabling wide speculation, as “meme investors” often look for disproportionate short-term returns.
Retail investing is the act of non-professional investors buying and selling securities for their own purposes. Retail investing has become popular with the rise of zero commissions digital platforms enabling anyone with small portfolio to trade.
Accredited investors are individuals or entities deemed sophisticated enough to purchase securities that are not bound by the laws that protect normal investors. These may encompass venture capital, angel investments, private equity funds, hedge funds, real estate investment funds, and specialty investment funds such as those related to cryptocurrency. Accredited investors, therefore, are individuals or entities permitted to invest in securities that are complex, opaque, loosely regulated, or otherwise unregistered with a financial authority.
Startup valuation describes a suite of methods used to value companies with little or no revenue. Therefore, startup valuation is the process of determining what a startup is worth. This value clarifies the company’s capacity to meet customer and investor expectations, achieve stated milestones, and use the new capital to grow.
Profit is the total income that a company generates from its operations. This includes money from sales, investments, and other income sources. In contrast, cash flow is the money that flows in and out of a company. This distinction is critical to understand as a profitable company might be short of cash and have liquidity crises.
Double-entry accounting is the foundation of modern financial accounting. It’s based on the accounting equation, where assets equal liabilities plus equity. That is the fundamental unit to build financial statements (balance sheet, income statement, and cash flow statement). The basic concept of double-entry is that a single transaction, to be recorded, will hit two accounts.
The purpose of the balance sheet is to report how the resources to run the operations of the business were acquired. The Balance Sheet helps to assess the financial risk of a business and the simplest way to describe it is given by the accounting equation (assets = liability + equity).
The income statement, together with the balance sheet and the cash flow statement is among the key financial statements to understand how companies perform at fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at profit or loss (also called P&L statement).
The cash flow statement is the third main financial statement, together with income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing and financing. The cash flow statement can be prepared with two separate methods: direct or indirect.
The capital structure shows how an organization financed its operations. Following the balance sheet structure, usually, assets of an organization can be built either by using equity or liability. Equity usually comprises endowment from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).
Capital expenditure or capital expense represents the money spent toward things that can be classified as fixed asset, with a longer term value. As such they will be recorded under non-current assets, on the balance sheet, and they will be amortized over the years. The reduced value on the balance sheet is expensed through the profit and loss.
Financial statements help companies assess several aspects of the business, from profitability (income statement) to how assets are sourced (balance sheet), and cash inflows and outflows (cash flow statement). Financial statements are also mandatory to companies for tax purposes. They are also used by managers to assess the performance of the business.
Financial modeling involves the analysis of accounting, finance, and business data to predict future financial performance. Financial modeling is often used in valuation, which consists of estimating the value in dollar terms of a company based on several parameters. Some of the most common financial models comprise discounted cash flows, the M&A model, and the CCA model.
Business valuations involve a formal analysis of the key operational aspects of a business. A business valuation is an analysis used to determine the economic value of a business or company unit. It’s important to note that valuations are one part science and one part art. Analysts use professional judgment to consider the financial performance of a business with respect to local, national, or global economic conditions. They will also consider the total value of assets and liabilities, in addition to patented or proprietary technology.
The Weighted Average Cost of Capital can also be defined as the cost of capital. That’s a rate – net of the weight of the equity and debt the company holds – that assesses how much it cost to that firm to get capital in the form of equity, debt or both.
A financial option is a contract, defined as a derivative drawing its value on a set of underlying variables (perhaps the volatility of the stock underlying the option). It comprises two parties (option writer and option buyer). This contract offers the right of the option holder to purchase the underlying asset at an agreed price.
A profitability framework helps you assess the profitability of any company within a few minutes. It starts by looking at two simple variables (revenues and costs) and it drills down from there. This helps us identify in which part of the organization there is a profitability issue and strategize from there.
The Triple Bottom Line (TBL) is a theory that seeks to gauge the level of corporate social responsibility in business. Instead of a single bottom line associated with profit, the TBL theory argues that there should be two more: people, and the planet. By balancing people, planet, and profit, it’s possible to build a more sustainable business model and a circular firm.
Behavioral finance or economics focuses on understanding how individuals make decisions and how those decisions are affected by psychological factors, such as biases, and how those can affect the collective. Behavioral finance is an expansion of classic finance and economics that assumed that people always rational choices based on optimizing their outcome, void of context.
Gennaro is the creator of FourWeekMBA, which reached about four million business people, comprising C-level executives, investors, analysts, product managers, and aspiring digital entrepreneurs in 2022 alone | He is also Director of Sales for a high-tech scaleup in the AI Industry | In 2012, Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy.
Discover more from FourWeekMBA
Subscribe now to keep reading and get access to the full archive.
