Arbitrage Opportunities in Arbitrage-Free Models of Bond Pricing / David Backus, Silverio Foresi, Stanley Zin.

Format:

Book

Author/Creator:

Backus, David.

Contributor:

National Bureau of Economic Research.

Foresi, Silverio.

Zin, Stanley.

Series:

Working Paper Series (National Bureau of Economic Research) no. w5638.

NBER working paper series no. w5638

Language:

English

Physical Description:

1 online resource: illustrations (black and white);

Place of Publication:

Cambridge, Mass. National Bureau of Economic Research 1996.

Summary:

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 selected 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.

Notes:

Print version record

June 1996.