Final answer:
Arbitrage is based on the Law of One Price and the No Free Lunch rule, which together imply that risk-free profit opportunities from price differentials are temporary as markets are efficient and such disparities are quickly exploited by traders.
Step-by-step explanation:
The subject in question pertains to the rules of arbitrage, which is a concept in the field of finance and economics. Arbitrage involves taking advantage of price differentials in different markets for the purpose of earning a profit without any risk. Specifically, arbitrage is based on two fundamental principles:
- Law of One Price: This principle asserts that identical goods or securities should have the same price when exchange rates are taken into account. This is premised on the efficient market hypothesis, which suggests that prices in competitive markets reflect all available information. Therefore, discrepancies in pricing are opportunities for arbitrage as traders buy low in one market and sell high in another until prices converge.
- No Free Lunch: This rule posits that it is impossible to generate guaranteed profits above the average market returns without taking additional risk. In the context of arbitrage, this means that such opportunities are typically short-lived as other market participants will also seek to capitalize on these disparities, thus quickly eliminating the price differences.
Historically, as transportation and communication networks improved, opportunities for arbitrage have diminished because it became easier to align prices across different regions. However, new opportunities continue to present themselves in various forms, such as spatial arbitrage, temporal arbitrage, and statistical arbitrage, keeping the principles of arbitrage relevant in the financial world.