Thursday, July 18, 2019

The Law of One Price in Financial Markets

The Law of One Price in Financial Markets Owen A. Lamont and Richard H. Thaler The Law of One Price is an economic way of rational perspective to explain the expectation of price uniformity of a particular commodity or say any economics goods across national boundaries. The law tries to explain what a market price condition of a given goods should be, all things being equal, across global boundaries. This law will hold where every variable that has a causality effect on price variation are held constant.That is where there is absence of transaction cost and no restriction or barrier to trades Lamont and Thaler (2003) try to use real word scenario to explain the functionality and effectiveness of the law of one price. Under the assumption that the law could be realistic in completive market with no transaction and barrier to trade cost. The point of interest is to see whether this law could be violated. Using the aspirin market as an example, Lamont and Thaler are able to justify that it is very easy to violate the law in a consumer goods market.There are many factors that shape the consumer buying decision and some of these factors can actually lead to the violation of the law of one price. Example of such factors may include consumer foreknowledge about a product, influence of friends and family, perception about substitute goods or similar goods with brand variation. Owing to the factors that influence consumers buying decision of a consumers goods, it is difficult for Arbitrageur to have any influence in consumer goods market thereby causing the violation of the law of one price .Lamont and Thaler says there exist no open way to sell short a consumer product and because of preconception about a consumer product by the consumer, it is very difficult to predict when consumer will see the error in their way. In most instances, consumers realize their mistakes during post purchase evaluation Thaler and Lamont try to find see if the Law of one price is actually b eing kept in the financial market where there is room for short selling and transaction cost are pretty low. Using several examples from the financial arket, it is obvious that this law is being violated more often. Closed end investment fund or mutual fund case sighted by Thaler and Lamont might seems to be in violation of the Law of one price, but obviously from the analysis, the closed end mutual fund security and the underlying asset are not identical. And the fee charge by a fund manager for his service is somewhat rational. On the other hand, the ADR example using the Infosys example reflects the violation of the law of one price as obviously there are large discrepancies between the two prices.In the case of Twin share of Ryal Dutch and Shell, it is surprising that Royal Dutch was selling at a higher value than Dell even though it is pretty much a share of the same company but after the announcement that the US is dropping all foreign share, the market quickly reacted to the information and the premium on Royal Dutch dropped from 6% to 1% within 24 hours. Obviously, it the incident is a clear indication of the violation of the law of one price considering the fact that there are room for short selling and an ample opportunity for arbitrager to even get involvedConsidering all the cases presented by Thaler and Lamont, it is submitted that economists do need to focus more on whether the market is sending the right signal to the to the market participants or not. It can be concluded from the case studies that the law of one price should hold only if the same asset is selling at different price in different market simultaneously, then the arbitrageurs could step in take advantages of price differences which will allow it to make some pretty money for him/her self before the market get to equilibrium.However, it is logical to say that no two securities are completely identical. Nonetheless, it may be reasonable to say that arbitrageurs could still make some decent living in the presence of imperfect information in the financial market Work Cited Lamont, Owen A. and Richard H. Thaler. Journal of Economic Perspectives—Volume 17, Number 4—Fall 2003—Pages 191–202

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