Arbitrage Condition

Suppose there are two riskless assets offering rates of return r and rí, respectively. Assuming no transaction costs, one of the strongest statements that can be made in positive economics is that r ľ r0: (A) This is based on the law of one price, which says that the same good cannot sell at different prices. In terms of securities, the law of one price says that securities with identical risks must have the same expected return. Essentially, equation (A) is a arbitrage condition that must be expected to hold in all but the most extreme circumstances. This is because if r r0, the first riskless asset could be purchased with funds obtained from selling the second riskless asset. This arbitrage transaction would yield a return of r r0 without having to make any new investment of funds or take on any additional risk. In the process of buying the first asset and selling the second, investors would bid up the formerís price and bid down the latterís price. This repricing mechanism would continue up to the point where these two assetsí respective prices equaled each other. And thus r ľ r0.