In an efficient market, the price of an asset (almost always) reflects its fair value, because when it doesn't an arbitrage opportunity exists. Arbitrage opportunities are exploited by investors until they disappear, and they disappear fast because of the competition between investors. In other words, any mispricing in an efficient market cannot last long as investors compete to earn arbitrage profits.
But, how do investors actually exploit arbitrage opportunities? The principle is to buy cheap and sell dear. Let us give you an example. Suppose that iPhones are selling for $800 in the US and for £500 in the UK. Moreover, suppose that the current exchange rate is £1 = $2. Then, an iPhone is worth more in the UK, since £500 = $1,000 > $800.
Then, a US investor can take advantage of this mispricing with the following trading strategy:
- Buy an iPhone in the US for $800.
- Sell it in the UK for £500.
- Convert £500 into $1,000.
This yields an arbitrage profit of $1,000 - $800 = $200. Note that this is the arbitrage profit per iPhone. If you followed this strategy with 1,000 iPhones, you would make a profit of $200,000.
Of course, this example is very simplistic as it ignores transaction costs (taxes, transportation costs, etc.) and the exchange rate risk. These factors can lower the arbitrage profit substantially. Still, the principle is sound: When investors notice mispricings, they try to buy cheap and sell dear.
As we mentioned in the beginning, mispricings disappear quickly in efficient markets. This is because the trading strategies that exploit mispricings work in a way that pulls prices back to their fair levels. In our example, investors would keep buying iPhones in the US and selling them in the UK, until the US price goes up and the UK price goes down until there is no longer a mispricing. For instance, if the US price goes up to $900 and the UK price goes down to £450, iPhones cost exactly the same in both countries, since £450 = $900 at the current exchange rate. The more efficient the market is, the faster the mispricing disappears.
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As we mentioned in the beginning, mispricings disappear quickly in efficient markets. This is because the trading strategies that exploit mispricings work in a way that pulls prices back to their fair levels. In our example, investors would keep buying iPhones in the US and selling them in the UK, until the US price goes up and the UK price goes down until there is no longer a mispricing. For instance, if the US price goes up to $900 and the UK price goes down to £450, iPhones cost exactly the same in both countries, since £450 = $900 at the current exchange rate. The more efficient the market is, the faster the mispricing disappears.
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