The law of one price is an economic principle that states that when certain variables are weighed, the price of an equivalent asset or commodity will have the same price globally, irrespective of location.

Where there are no transaction costs, shipping costs or regulatory constraints, currency exchange rates are the same and there is no price manipulation by buyers or sellers, the rule of one price takes into account a frictionless market. The rule of one price persists because, because of the arbitration incentive, discrepancies between asset prices in different locations will inevitably be removed.

The ability to arbitrate will be done by a trader purchasing the commodity at a lower price available on the market and then selling it on the market where it is available at a higher price. The price of the commodity will be aligned over time by market equilibrium forces.

Understanding Law of One Price

The rule of one price is the basis for parity of buying power. Purchasing power parity states that when a basket of equivalent goods is priced the same in both nations, the value of two currencies is equal. It ensures that consumers across global markets have the same buying power.

In fact, due to different trading costs and the inability to enter markets for certain individuals, purchasing power parity is difficult to achieve.

In comparing prices across markets that trade in different currencies, the formula for purchasing power parity is useful in that it can be applied. As exchange rates can change regularly, it is possible to recalculate the formula on a regular basis to consider mispricing across different foreign markets.