Law of One Price is a crucial part of Arbitrage. Essentially, Law of one price creates an arbitrage if this law is violated. In order for us fully understand what is law of one price, we have to know what Arbitrage is. Arbitrage term is mainly applied to investment trading. Practice where profits can be made due to the price difference between two or more investing institutes or markets called arbitrage.

Law of one price states that similar products should have relatively similar prices, otherwise products would be bought for one price and resale for another price creating an unjustifiable price difference and therefore an arbitrage. In a quick example we can take gold, silver and other valuable metals. If we buy gold in United States for one price and in China I can sell it for a higher price, this will create a violation of the Law of one price.

Similarly Law of one price can be used in investing as well. Regardless of how investments are made, same investments must have same price. Investments can be created differently using securities and other assets, however, investments can be considered identical only when investments have same expected cash flow. Similarly to gold example, when difference in prices for investments is created, arbitrage is created and money can be made on the difference between lower and higher price.

We know that arbitrage is the price difference between one market and another and that violation of the Law of One Price creates that’s that difference, it becomes clear that this law is very vital in investment world. Law of one price creates an opportunity for investors create a profit virtually risk free. Arbitrage created due to the law of one price more like an exception from the rule rather than a rule; therefor it is rear in investing world. As a result arbitragers look very close to use this opportunity to gain profit that way.

Sources:

http://www.whartonsp.com/articles/article.aspx?p=417513

http://www.riskglossary.com/link/law_of_one_price.htm

http://www.investorwords.com/2725/law_of_one_price.html

http://papers.nber.org/papers/w8112

http://faculty.chicagobooth.edu/richard.thaler/research/lawof.pdf