12 MATHEMATICAL TECHNIQUES IN FINANCE

The usual arbitrage pricing argument relates the future cash flows of a
financial instrument to those of a risk-free investment, for example, deposit-
ing money at a bank account and receiving the simple interest rate r for a
future date T. We use the relationship

1
D = D(T) =
1 + rT

as today’s value of receiving 1 at T. We assume we can invest (lend) and

borrow for T at the same rate r.
Now consider the simplest financial instrument whose only cash flow is
payment of 1 at T, and let P be today’s price of this instrument. If P < D,
then we could borrow D at the rate r and pay P for the instrument, and be
left with a positive amount D − P > 0. At time T we will receive 1 from the
instrument, while we owe D × (1 + rT) = 1 to whoever lent it to us. These
future cash flows exactly offset, and we have therefore made a profit today
of D − P with no risk.
Alternatively, let P > D. In this case, we sell the instrument for P and
lend/invest part of it, D, at r. Again, we are left with a positive amount
P − D > 0. At time T, we will receive D × (1 + rT) = 1 from whoever we
lent to, and need to pay 1 to whoever we sold the instrument to. These two
cash flows exactly offset and we have made a profit of P − D with no risk.
Therefore, in an arbitrage-free economy, today’s price, D, of the
instrument consisting of receiving 1 at T cannot be different than D(T) =
1∕(1 + rT).
Note that when P < D, the instrument’s price is too low and its yield
too high, and we can lend at this high yield while financing/borrowing at
the lower rate r. On the other hand, when P > D, the price is too high and
the yield too low, so we borrow at this low yield and lend/invest at the
higher rate r. Lack of arbitrage can then be expressed as absence of bor-
row low, lend high opportunities. If such opportunities exist, then investors
will start buying the cheap (high-yield) instrument and drive up its price,
or sell the expensive (low-yield) instrument and drive down its price to the
no-arbitrage price.

2.3 PRICE-YIELD FORMULA

Discount factors are the fundamental building blocks for valuing fixed
income securities. Given a series of known cash flows (C1 , . . . , CN ) to