TY  - JOUR
AU  - Backus,David
AU  - Foresi,Silverio
AU  - Zin,Stanley
TI  - Arbitrage Opportunities in Arbitrage-Free Models of Bond Pricing
JF  - National Bureau of Economic Research Working Paper Series
VL  - No. 5638
PY  - 1996
Y2  - June 1996
UR  - http://www.nber.org/papers/w5638
L1  - http://www.nber.org/papers/w5638.pdf
N1  - Author contact info:
David Backus
Stern School of Business
NYU
44 West 4th Street
New York, NY 10012-1126
Tel: 212/998-0873
Fax: 212/995-4221
E-Mail: dbackus@stern.nyu.edu

Silverio Foresi
Salomon Smith Barney
Emerging Markets Derivatives and
Structured Products
388 Greenwich Street
11th Floor
New York, NY  10013

Stanley E. Zin
Department of Economics
Leonard N. Stern School of Business
New York University
44 West 4th Street, Suite 7-91
New York, NY 10012-1126
Tel: 212/998-0121
E-Mail: stan.zin@nyu.edu
AB  - 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.
ER  -