9780321818171_berk_ch03

The practice of buying and selling equivalent goods

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Unformatted text preview: ation in which it is possible to make a profit without taking any risk or making any investment. The practice of buying and selling equivalent goods in different markets to take advantage of a price difference is known as arbitrage. More generally, we refer to any situation in which it is possible to make a profit without taking any risk or making any investment as an arbitrage opportunity. Because an arbitrage opportunity has positive NPV, whenever an arbitrage opportunity appears in financial markets, the Valuation Principle indicates that investors will race to take advantage of it. Those investors who spot the opportunity first and who can trade quickly will have the ability to exploit it. Once they place their trades, prices will respond due to the interaction of supply and demand forces, causing the arbitrage opportunity to evaporate. Arbitrage opportunities are like money lying in the street; once spotted, they will quickly disappear. Thus, the normal state of affairs in markets should be that no arbitrage opportunities exist. Law of One Price In a compe...
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