Arbitrage Opportunities in Arbitrage-Free Models of Bond Pricing

41 Pages Posted: 13 Jul 2000 Last revised: 25 Mar 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

Carnegie Mellon University; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: June 1996

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.

Suggested Citation

Backus, David K. and Foresi, Silverio and Zin, Stanley E., Arbitrage Opportunities in Arbitrage-Free Models of Bond Pricing (June 1996). NBER Working Paper No. w5638. Available at SSRN: https://ssrn.com/abstract=225560

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Silverio Foresi

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

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Stanley E. Zin

Carnegie Mellon University ( email )

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United States

National Bureau of Economic Research (NBER)

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United States

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