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Please use this identifier to cite or link to this item:
http://hdl.handle.net/2451/26924
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| Title: | Arbitrage Opportunities in Arbitrage-Free Models of Bond Pricing |
| Authors: | David, Backus
Foresi, Silverio
Zin, Stanley |
| Keywords: | bond yields
options
fixed income derivatives
pricing kernels
state contingent claims
time-dependent drift volatility |
| Issue Date: | 16-Apr-1996 |
| Series/Report no.: | FIN-96-008 |
| Abstract: | Mathematical models of bond pricing are used by both academics and Wall
Street practitioners, with practitioners introducing time-dependent
parameters to fit “arbitrage-free” models to select asset
prices. We show, in a simple one-factor setting, that the ability of
such models to reproduce a subset of security prices need not extend to
state-contingent claims more generally. The popular Black-Derman-Toy
model, for example, overprices call options on long bonds relative to
those on short bonds when interest rates exhibit mean reversion. We
argue, more generally, that the additional parameters of arbitrage-free
models should be complemented by close attention to fundamentals, which
might include mean reversion, multiple factors, stochastic volatility,
and/or non-normal interest rate distributions. |
| URI: | http://hdl.handle.net/2451/26924 |
| Appears in Collections: | Finance Working Papers
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