Law Of One Price Flashcards
What is the Law of One Price (LOOP) in financial markets?
LOOP states that identical financial assets should have the same price in an efficient market.
What are the key barriers that prevent arbitrage from enforcing the Law of One Price?
- Legal and trading restrictions
- Low liquidity
- Short-selling constraints
- Exchange rate fluctuations
- Malicious market activity (e.g., pump-and-dump schemes).
What role do investor misperceptions play in LOOP violations?
Investors sometimes mistakenly believe there are fundamental differences between identical assets, leading to demand and supply imbalances that distort prices.
Why doesn’t arbitrage always eliminate LOOP violations?
Real-world arbitrage faces constraints such as trading restrictions, legal barriers, and behavioral biases that prevent price equalization.
How do closed-end country funds demonstrate LOOP violations?
Legal and institutional barriers prevent direct investment, causing closed-end funds to trade at significant premiums or discounts to their NAVs.
What are some historical examples of LOOP violations in closed-end country funds?
- Taiwan Fund (1987) traded at a 205% premium due to U.S. investment restrictions.
- Germany Fund (1989) surged to a 100% premium after the fall of the Berlin Wall.
How do American Depositary Receipts (ADRs) illustrate LOOP violations?
ADRs, which represent foreign stocks trading in the U.S., sometimes trade at significantly different prices from their underlying shares due to legal and institutional constraints.
What is an example of an ADR that violated LOOP?
Infosys (2000) ADRs traded at a 136% premium to shares on the Bombay Stock Exchange due to trading restrictions and a lack of arbitrage mechanisms.
How do corporate spinoffs contribute to LOOP violations?
Investors fail to properly value subsidiary shares distributed in spinoffs, leading to stub value anomalies where the sum of parts is mispriced.
What factors contribute to market inefficiencies that prevent LOOP from holding?
Restrictions on short-selling, legal constraints, and behavioral biases create persistent price discrepancies.
Why is real-world arbitrage not always risk-free?
Arbitrageurs face risks such as noise trader risk, unpredictable price movements, and systemic market failures (e.g., LTCM collapse in 1998).
How do LOOP violations challenge classical finance theories?
Traditional finance assumes arbitrage is frictionless and markets price assets correctly, but real-world frictions prevent price convergence.
What is noise trader risk, and how does it impact arbitrage?
Noise traders make irrational trades that push prices away from fair value, increasing risk for arbitrageurs and deterring price corrections.
Why did the Long-Term Capital Management (LTCM) hedge fund collapse despite arbitrage strategies?
LTCM relied on arbitrage strategies assuming LOOP would hold, but extreme market conditions caused spreads to widen, leading to massive losses.
How do limits to arbitrage explain the persistence of mispricings?
Arbitrage is limited by capital constraints, market frictions, and the risk that prices may diverge further before converging.
How does investor sentiment contribute to LOOP violations?
Overly optimistic or pessimistic sentiment can drive asset prices away from their fundamental values, sustaining LOOP violations.
What implications do LOOP violations have for asset pricing models?
LOOP violations suggest that real-world markets are less efficient than assumed in standard pricing models, requiring adjustments for frictions and investor irrationality.
