Arbitrage Opportunities in Arbitrage-Free Models of Bond Pricing
42 Pages Posted: 11 Nov 2008
Date Written: October 1994
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
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