Skip navigation

Arbitrage Opportunities in Arbitrage-Free Models of Bond Pricing

Authors: Backus, David K.
Foresi, Silverio
Zin, Stanley E.
Keywords: bond prices and yields;forward rates;time-dependent drift and volatility;options
Issue Date: 25-Oct-1994
Series/Report no.: FIN-94-005
Abstract: We explore the practitioners’ methodology of choosing time-dependent parameters to fit a bond model to selected asset prices, and show that it can lead to systematic mispricing of some assets. The Black-Derman-Toy model, for example, is likely to overprice call options on long bonds when interest rates exhibit mean reversion. This mispricing can be exploited, even when no other traders offer the mispriced assets. We argue more generally that time-dependent parameters cannot substitute for sound fundamentals.
Appears in Collections:Finance Working Papers

Files in This Item:
File Description SizeFormat 
wpa94005.pdf1.22 MBAdobe PDFView/Open

Items in FDA are protected by copyright, with all rights reserved, unless otherwise indicated.