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Concept
Rational pricing
Summary
Rational pricing is the assumption in financial economics that asset prices – and hence asset pricing models – will reflect the arbitrage-free price of the asset as any deviation from this price will be "arbitraged away". This assumption is useful in pricing fixed income securities, particularly bonds, and is fundamental to the pricing of derivative instruments.
Arbitrage is the practice of taking advantage of a state of imbalance between two (or possibly more) markets. Where this mismatch can be exploited (i.e. after transaction costs, storage costs, transport costs, dividends etc.) the arbitrageur can "lock in" a risk-free profit by purchasing and selling simultaneously in both markets.
In general, arbitrage ensures that "the law of one price" will hold; arbitrage also equalises the prices of assets with identical cash flows, and sets the price of assets with known future cash flows.
The same asset must trade at the same price on all markets ("the law of one price").
Where this is not true, the arbitrageur will:
buy the asset on the market where it has the lower price, and simultaneously sell it (short) on the second market at the higher price
deliver the asset to the buyer and receive that higher price
pay the seller on the cheaper market with the proceeds and pocket the difference.
Two assets with identical cash flows must trade at the same price. Where this is not true, the arbitrageur will:
sell the asset with the higher price (short sell) and simultaneously buy the asset with the lower price
fund his purchase of the cheaper asset with the proceeds from the sale of the expensive asset and pocket the difference
deliver on his obligations to the buyer of the expensive asset, using the cash flows from the cheaper asset.
An asset with a known price in the future must today trade at that price discounted at the risk free rate.
Note that this condition can be viewed as an application of the above, where the two assets in question are the asset to be delivered and the risk free asset.
Official source
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