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Arbitrage opportunities in arbitrage-free models of bond pricing

Author: David Backus; Silverio Foresi; Stanley E Zin; National Bureau of Economic Research.
Publisher: Cambridge, MA : National Bureau of Economic Research, ©1996.
Series: Working paper series (National Bureau of Economic Research), working paper no. 5638.
Edition/Format:   eBook : Document : EnglishView all editions and formats
Summary:
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 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  Read more...
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Material Type: Document, Internet resource
Document Type: Internet Resource, Computer File
All Authors / Contributors: David Backus; Silverio Foresi; Stanley E Zin; National Bureau of Economic Research.
OCLC Number: 70066259
Notes: "June 1996."
Description: 1 online resource (39 pages) : illustrations.
Series Title: Working paper series (National Bureau of Economic Research), working paper no. 5638.
Responsibility: David Backus, Silverio Foresi, Stanley Zin.

Abstract:

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 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.

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