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Chapter 7. Concept of Arbitrage > Theoretical Underpinnings of Arbitrage

Theoretical Underpinnings of Arbitrage

There are some economic theories that underpin the concept of arbitrage. These theories include the Efficient Market Hypothesis (EMH), the Law of One Price and the Purchasing Power Parity (PPP). These theories are discussed in brief in this section.

Efficient Market Hypothesis (EMH)

EMH is an investment theory that states it is impossible to “outperform the market” because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to the EMH, this implies that stocks always trade at their fair value on stock exchanges, making it impracticable for investors and traders to either buy undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and the only way an investor or trader can possibly obtain higher returns is by buying riskier investments.


  

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