AS a student of finance, I have always been fascinated by the Big Mac Index which The Economist invented in 1986 as a lighthearted guide to whether currencies are at their correct level. Briefly, it is based on the theory of purchasing power parity (PPP), the notion that in the long run exchange rates should move towards the rate that would equalize the prices of an identical basket of goods and services (in this case, a burger) in any two countries.
Thirty-six years have passed and burgernomics has flourished, becoming the subject of academic reviews and discussion. Today, The Economist continues to update and improve the methodology on how they calculate the Big Mac Index. Soft and fun at first sight, it is a very instructive introduction to the law of one price.
The law of one price states that in a competitive market, if two assets are equivalent, they will tend to have the same market price. There are specific conditions for this to happen. One, free competition allows the forces of supply and demand to run its dynamic effect. Two, trade frictions are absent such as tariffs, transportation fees and transaction costs. And three, everyone is a price taker and no one can manipulate prices.
To illustrate, let’s review the onions situation. If the price of onions is P600 per kilo in Manila, ask yourself what its price is in another country. The global average is reported to be around P85.00 a kilo. Consider how much it would cost to buy onions say, in Taiwan, and then sell it in Manila. There will be costs of shipping, handling, insuring, etc. If total transaction costs are less that the price differential, and you can delay paying for the onion purchase until you receive payment from selling it, then you avoid the financing cost and you will have engaged in a pure riskless arbitrage.
Arbitrage is the purchase and immediate sale of equivalent assets in order to earn a sure profit from a difference in their prices. If markets are efficient, this price discrepancy will be well known, and traders would get into the picture to take advantage of the gaps. In theory, succeeding transactions will close the price differential and arbitrage will force onion prices to correct and be the same in the two markets.
So, you might ask why onions remain expensive. Unfortunately, onions do not satisfy the law of one price conditions we earlier enumerated, i.e., free competition, trade friction (importation not allowed but smugglers suspected) and not everyone is a price taker in this commodity (unscrupulous speculators abound).
Here’s another simple arbitrage example I read about Warren Buffett. At 6 years old, he would purchase a six-pack Coca Cola soda for 25 cents and sell each bottle for 5 cents in his neighborhood, profiting 5 cents per pack. This the classic buy wholesale and sell by piece strategy. Even at a young age, Buffett intuitively adopted arbitrage tactics.
In my past corporate life, we had an officer who used to visit our Davao branch for corporate inspection and audit. I was told, he often travels with an empty suitcase going to the region but packs his bags with all sorts of provincial goods on his return. Simple repackaging of the goods provides profit through arbitrage of place.
Understanding the importance of doing arbitrage is a prime model for business development. If currency, commodity, security, or even goods like bags, sneakers, etc., are priced differently in two separate markets, traders buy the cheaper version and sell it at the higher price to make money.
The problem with arbitrage is pricing discrepancies are expected to be short-lived and small. Thus the strategy benefits the astute investor who can execute transactions with large sums of money while the market is in the process of correction. In the securities market, however, advances in technology and the digitization of the process are making it easier to identify and resolve pricing errors. Algorithm based trading in first world markets quickly spot and execute arbitrage opportunities. The machine is faster than humans in execution.
The more efficient the market is, the less the arbitrage opportunities. The internet is allowing better view of price differentials. There was a time when the globalization trend predicted full convergence of prices. Competition in financial markets predicted not only that the prices of assets would be the same, but also interest rates.
One emerging trend globally is protectionism by specific economies. The more this pattern continues, the less chances for prices to converge. If domestic and imported goods cannot be readily and easily substituted, higher input prices can increase domestic firm’s production costs and reduce household purchasing power. Inflation is one expected outcome. Consumption, investment, and employment are all negatively affected. The macroeconomy suffers.
Inefficiencies in the market, and the deterioration in trade allow more arbitrage openings. This is a case of bad news, good news, who knows? What is clear is that arbitrage remains a powerful tool for those fast enough in identifying the differences. Finding mismatches in prices provides opportunities to make less risky returns.
The views expressed herein are his own and does not necessarily reflect the opinion of his office as well as FINEX.
Benel Dela Paz Lagua was previously EVP and chief development officer at the Development Bank of the Philippines. He is an active FINEX member and an advocate of risk-based lending for SMEs. Today, he is independent director in progressive banks and in some NGOs.