Law of One Price

The Law of One Price is a fundamental economic concept stating that identical goods or Securities should trade for the same price everywhere, after accounting for the exchange rate. This assumes there are no Transaction Costs or barriers to trade. Think of it as the market's version of “a rose is a rose is a rose.” If a share of Apple Inc. trades on the NASDAQ, it should cost the same as a share of Apple Inc. trading on the Frankfurt Stock Exchange. This principle is the bedrock of the Efficient Market Hypothesis, which suggests that asset prices reflect all available information. The engine that drives this law is Arbitrage—the practice of simultaneously buying and selling an asset in different markets to profit from tiny price differences. In a perfectly efficient world, these arbitrage opportunities wouldn't exist, as they would be instantly exploited and eliminated, forcing prices to converge.

Imagine a can of Coke is sold for €1 in Paris and $1.50 in New York. If the exchange rate is exactly €1 = $1.50, the Law of One Price holds. But what if the Coke in Paris still costs €1, while the price in New York drops to $1.20? A savvy entrepreneur could theoretically buy mountains of Coke in New York, ship them to Paris, and sell them for a risk-free profit of $0.30 per can (minus shipping costs, of course). This buying pressure in New York and selling pressure in Paris would nudge the prices back toward equilibrium. This is the law in action—it's enforced by eagle-eyed market participants who pounce on these “free lunch” opportunities, paradoxically eliminating them in the process. This concept applies not just to soda but to any identical, or Fungible, asset, from gold bars to shares of a company. A macroeconomic extension of this idea is Purchasing Power Parity, which compares the price of a whole basket of goods between countries.

While elegant in theory, the Law of One Price faces a few bumps in the real world. Prices for the same item often differ across locations, and these differences can persist.

The heroes (or villains, depending on your view) of this story are Arbitrageurs. These are traders who make a living from exploiting temporary deviations from the Law of One Price. When they spot a mispricing—like a Dual-listed Company whose stock trades cheaper in London than in Hong Kong—they swoop in. They buy the underpriced stock and sell the overpriced one. This coordinated action increases demand for the cheaper asset and supply for the pricier one, pushing their prices together until the opportunity for a risk-free profit vanishes. This is the market’s self-correcting mechanism, and it's remarkably powerful.

So, if arbitrage is so effective, why do price differences exist at all? Several real-world frictions can get in the way:

• Transaction Costs: The most obvious culprit. If the cost of shipping that Coke from New York to Paris, plus insurance and handling fees, is more than the $0.30 price difference, the arbitrage opportunity disappears. For financial assets, these costs include brokerage fees, bid-ask spreads, and other charges.
• Taxes and Tariffs: Governments can throw a wrench in the works. A tariff on imported goods or different tax treatments for capital gains in different countries can create a permanent wedge between prices.
• Information Asymmetry: One market might have information that another doesn't, leading to a temporary price discrepancy until the news spreads.
• Legal and Regulatory Barriers: Some assets can't be freely traded across borders. Capital Controls, for instance, can restrict the flow of money in and out of a country, making arbitrage impossible.

For a Value Investor, the Law of One Price isn't just an academic theory; it's a treasure map. While perfect arbitrage opportunities are rare and fleeting, violations of the law can signal deeper market inefficiencies and potential bargains. When you see a situation that seems to defy the Law of One Price, it’s a bright red flag telling you to dig deeper. Consider these examples:

1. Holding Companies: A holding company that owns shares in several other publicly traded businesses might trade at a significant discount to the sum of its parts. In theory, the holding company's stock price should reflect the value of the assets it owns. When it doesn't, a value investor asks: Why? Is it due to poor management, high corporate overhead, or is the market simply overlooking the underlying value?
2. Closed-End Funds: A Closed-end Fund can trade at a price significantly different from its Net Asset Value (NAV). This means you could be buying a basket of stocks for, say, $0.80 on the dollar. The law of one price would suggest the fund's price and its NAV should be the same. The discount is an inefficiency that a patient investor might exploit, hoping the gap will narrow over time.

The key takeaway is this: deviations from the Law of One Price are where the most interesting investment stories often begin. They represent a departure from rationality and efficiency, creating the very mispricings that value investing is designed to uncover.