Working Paper: NBER ID: w5638
Authors: David Backus; Silverio Foresi; Stanley Zin
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.
Keywords: bond pricing; arbitrage-free models; mean reversion; options pricing
JEL Codes: G12; G13
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| arbitrage-free models (G19) | ability to accurately price bonds (G12) |
| time-dependent parameters (C22) | pricing inaccuracies (L11) |
| model structure (C52) | pricing inaccuracies (L11) |
| inaccuracies in model specifications (C51) | arbitrage opportunities (F31) |
| mean reversion (C22) | pricing of state-contingent claims (G13) |
| arbitrage-free models (G19) | overpricing of long bond options (G13) |
| arbitrage-free models (G19) | pricing of short bond options (G12) |