4. Arbitrage & the Law of One Price
Arbitrage
Arbitrage is a fundamental concept in economics and finance that involves taking advantage of a price difference between two or more markets. It's a strategy used by traders and investors to profit from market inefficiencies.
(금융과 경제에서 "Arbitrage"는 한글로 "차익거래"라고 한다. 이 용어는 시장 간의 가격 차이를 이용해 이익을 얻는 거래 방식을 의미한다.)
How It Works:
- Identifying Price Differences: Arbitrageurs look for situations where, for instance, a security, commodity, or currency is priced differently in two different markets.
- Simultaneous Transactions: They buy the asset where it's cheaper and sell it where it's more expensive. These transactions often happen almost simultaneously to minimize risk.
- Risk-Free Profit: Ideally, arbitrage is considered a risk-free profit, as the transactions are meant to exploit price differences without any market risk.
Types of Arbitrage:
- Spatial Arbitrage: Buying and selling the same asset in different locations or markets.
- Temporal Arbitrage: Taking advantage of price differences of the same asset in the same market but at different times.
- Statistical Arbitrage: Using complex mathematical models to identify and exploit temporary price differences.
Impact on Markets:
- Market Efficiency: Arbitrage plays a crucial role in ensuring market efficiency by eliminating price discrepancies.
- Price Correction: When arbitrageurs buy low and sell high, they drive up the price in the low-priced market and drive down the price in the high-priced market, bringing prices into alignment.
The Law of One Price
This is a fundamental economic principle that underpins the concept of arbitrage.
Definition:
The Law of One Price states that in an efficient market, identical goods should sell for the same price when costs such as transportation and taxes are considered.
Implications:
- No Arbitrage Condition: If the Law of One Price did not hold, it would lead to arbitrage opportunities. In reality, small differences might exist due to transaction costs or informational delays, but significant differences are rare and short-lived.
- Basis for Pricing Models: This law is the foundation for many financial models and theories, as it assumes that if discrepancies arise, they are quickly corrected by market forces.
Efficient Markets:
- Theory vs. Reality: In theory, efficient markets should always adhere to the Law of One Price. However, in practice, markets can be inefficient due to factors like information asymmetry, transaction costs, or regulatory barriers.
- Role of Arbitrageurs: In inefficient markets, arbitrageurs play a key role in moving the market toward efficiency by exploiting and thereby correcting price discrepancies.
Real-World Example
An easy-to-understand example of arbitrage is currency exchange. If the exchange rate for USD/EUR is lower in the U.S. than in Europe, a trader could buy dollars for euros in the U.S. and sell them in Europe at a higher rate, making a profit. Over time, these actions would help equalize the exchange rates in both markets.
In summary, arbitrage is the practice of profiting from price differences in different markets, and the Law of One Price is a principle stating that in efficient markets, identical goods should have the same price. Arbitrage activities help ensure that markets adhere to this law, promoting efficiency and uniformity in pricing.
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