Rational pricing

In financial economics, rational pricing is the assumption that asset pricing models must reflect the arbitrage-free price of the asset This argument underpins the fundamental theorem of asset pricing, and is a key aspect of mathematical finance, defining the pricing of derivatives and fixed income securities, and useful, also, in setting exchange rates, and in pricing shares, at the least aligning prices correctly.

The essential argument is that where a mismatch exists between two or more markets, arbitrage will occur such that the arbitrageur makes a risk-free profit by purchasing and short-selling simultaneously in both markets. By doing so, the arbitrageur may deliver the purchased asset to the buyer, receiving that higher price, whilst paying the seller on the cheaper market with the proceeds and pocketing the difference. As such, the law of one price holds across trading exchanges; prices of assets with identical cash flows equalise; and the price of assets with known future cash flows may be calculated in advance.

A fundamental distinction exists between theoretical pricing models, which derive fair-value mathematical relationships by assuming an arbitrage-free market, and arbitrage trading strategies, which market participants execute to monetize temporary real-world price discrepancies. The former are the focus of financial economics.