October 18, 2010

Flynn, Sean Masaki (2003). Limited Arbitrage, Segmentation, and Investor Heterogeneity: Why the Law of One Price
So Often Fails, Vassar College Department of Economics Working Paper Series, Vassar College
Department of Economics.

We have been reminded again regarding the Law of One Price (LOP) last October 18 lecture and I am a bit surprised that LOP has a broad application. This paper that I’ve found applies LOP, particularly its failure to be consistent, in the capital markets. During this stage of the lecture I have (or maybe we have) this kind of a bias that LOP only applies to different countries/places and goods are more like bounded within tradable/tangible and services, but, when I saw this paper, I realized that LOP can even capture capital market assets, particularly those with identical payout streams being priced in variation.

The paper discovered that these violations of LOP were coming from two factors:

1) differences in investors’ asset valuations, wherein if there are two groups of investors trading in segmented markets, they are more likely to set different prices because they have different expectations or even speculations as to the real value of identical assets;

2) limitations in arbitrage activities are causing the heterogeneity in asset valuations, where those assets facing short sales constraints have an asymmetric distribution of pricing violations, because short sales constraints only bind when asset prices are too high, while those assets encountering noise trader risk have symmetric violation distributions because noise trader risk must be born by arbitrageurs both when prices are too low as well as too high.