Definition
Rational pricing is the assumption in financial economics that asset prices 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.
What is ‘Rational Pricing’
A financial theory that contends that the market prices of assets will represent the arbitrage-free pricing level for those assets. This is based on the assumption that any deviation from arbitrage-free price levels for an asset will result in arbitrageurs immediately trading away the profit opportunity on the asset until it trades at an arbitrage-free price.
Explaining ‘Rational Pricing’
A typical example of where the theory of rational pricing would be expected to come into play would be two identical assets trading in different markets. If the asset traded at a lower price in one market, an arbitrage trader would attempt to make a risk-free profit by purchasing the asset in the cheaper market by short selling the asset in the more expensive market. With enough volume, this arbitrage trading would cause the prices in both markets to converge to an equal value, removing the arbitrage opportunity.
Further Reading
- Rational pricing of internet companies – www.tandfonline.com [PDF]
- Rational herding in financial economics – www.sciencedirect.com [PDF]
- Implications of data restrictions on performance measurement and tests of rational pricing – papers.ssrn.com [PDF]
- Bubbles, rational expectations and financial markets – www.nber.org [PDF]
- Rational pricing of water as an instrument of improving water use efficiency in the agricultural sector: a case study in Gujarat, India – www.tandfonline.com [PDF]
- Rational asset prices – onlinelibrary.wiley.com [PDF]
- Behavioral rationality in finance: The case of dividends – www.jstor.org [PDF]
- Behaviorial finance: Past battles and future engagements – www.tandfonline.com [PDF]
