Arbitrage Opportunities in Arbitrage-Free Models of Bond Pricing

42 Pages Posted: 11 Nov 2008

See all articles by David K. Backus

David K. Backus

NYU Stern School of Business; National Bureau of Economic Research (NBER)

Silverio Foresi

Goldman Sachs Group, Inc. - Quantitative Strategy Group

Stanley E. Zin

New York University (NYU); National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: October 1994

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.

Keywords: bond prices and yields, forward rates, time-dependent drift and volatility, options

Suggested Citation

Backus, David K. and Foresi, Silverio and Zin, Stanley E., Arbitrage Opportunities in Arbitrage-Free Models of Bond Pricing (October 1994). NYU Working Paper No. FIN-94-005. Available at SSRN: https://ssrn.com/abstract=1298808

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Silverio Foresi

Goldman Sachs Group, Inc. - Quantitative Strategy Group ( email )

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Stanley E. Zin

New York University (NYU) ( email )

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