Transactions costs and the law of one pric

This study investigates the validity of the law of one price (LOP) in the presence of transactions costs. The LOP theory posits that arbitrage-induced trade ensures that price differences of homogenous commodities between markets exhibit a tendency to decrease over time. A vast majority of conventional studies depict the behavior of deviations from parity as a linear process. Adjustment in prices may, however, be discontinuous due to the impact of transactions costs on the profitability of engaging in arbitrage. This research examines the view that the neglect of this issue in the econometric modeling of the LOP is likely to yield results that may not be an accurate reflection of the true dynamics of spatial market arbitrage. The empirical methods are applied to price differences of several narrowly defined commodities as well as their respective detrended components.;A threshold autoregression (TAR) model is estimated to examine the distinctive convergence properties of small and large deviations. This procedure is consistent with the notion that price differences exhibit a propensity to converge only when such deviations exceed transactions costs. The parameter estimates obtained from the TAR procedure indicate that the explicit consideration of the role of transactions costs yields stronger support for the LOP than is implied by linear models.;Extensions to the basic analysis include the application of nonparametric techniques to price differences. An attractive feature of this method is that the estimation procedure is not contingent on the specification of a functional form. The examination yields useful evidence regarding departures from linearity of deviations from the LOP.;Impulse response functions are estimated for threshold models to consider the impact of shocks on a system that is nonlinear in structure. The empirical analysis yields mixed evidence with regard to the sensitivity of impulse, response functions to the magnitude, sign and timing of an exogenous disturbance.;Finally, observed costs of transportation between international wheat markets are employed to determine the efficiency of spatial arbitrage. The results indicate that markets appear to be more integrated when the influence of freight rates on the price adjustment mechanism is incorporated in the estimation procedure.