Download or read book Arbitrage Opportunities in Arbitrage-free Models of Bond Pricing written by David Backus and published by . This book was released on 1996 with total page 39 pages. Available in PDF, EPUB and Kindle. Book excerpt: 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