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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.
Appears in Collections:Finance Working Papers

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