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dc.contributor.authorDavid, Backus-
dc.contributor.authorForesi, Silverio-
dc.contributor.authorZin, Stanley-
dc.description.abstractMathematical 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.en
dc.subjectbond yieldsen
dc.subjectfixed income derivativesen
dc.subjectpricing kernelsen
dc.subjectstate contingent claimsen
dc.subjecttime-dependent drift volatilityen
dc.titleArbitrage Opportunities in Arbitrage-Free Models of Bond Pricingen
dc.typeWorking Paperen
Appears in Collections:Finance Working Papers

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