Arbitrage Opportunities in Arbitrage-Free Models of Bond Pricing

David Backus, Silverio Foresi and Stanley Zin

No 5638, NBER Working Papers from National Bureau of Economic Research, Inc

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.

JEL-codes: E43 G12 (search for similar items in EconPapers)
Date: 1996-06
Note: AP
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Published as Backus, David, Silverio Foresi and Stanley Zin. "Arbitrage Opportunities In Arbitrage-Free Models On Bond Pricing," Journal of Business and Economic Statistics, 1998, v16(1,Jan), 13-26.

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Related works:
Journal Article: Arbitrage Opportunities in Arbitrage-Free Models of Bond Pricing (1998)
Working Paper: Arbitrage Opportunities in Arbitrage-Free Models of Bond Pricing (1996)
Working Paper: Arbitrage Opportunities in Arbitrage-Free Models of Bond Pricing (1994)
Working Paper: Arbitrage Opportunities in Arbitrage-Free Models of Bond Pricing (1994)
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