The Meaning of Arbitrage-Free Valuation

 Arbitrage-free valuation refers to an approach to security valuation that determines security

values that are consistent with the absence of an arbitrage opportunity, which is an
opportunity for trades that earn riskless profits without any net investment of money
 In well-functioning markets, prices adjust until there are no arbitrage opportunities.
 The value of any financial assets is financial asset is equal to the present value of its
expected future cash flows.
The Law of One Price
 Arbitrage opportunities arise from violations of the law of one price. The law of one price
states that two goods that are perfect substitutes must sell for the same current price in the
absence of transaction cost.
Arbitrage Opportunity
 An arbitrage opportunity is a transaction that involves no cash outlay that results in a riskless
profit.
There are two types of arbitrage opportunities
1) Value additivity : when the value of whole differs from the sum of the values of parts.
EX.

This position generates a certain 5 today (100 – 95) and generates net 0 one year from today because cash
inflow for Asset B matches the amount for the 105 units of Asset A sold. An investor would repeat this
trade until the prices are equal.

2) Dominance:
 If both assets are risk-free, they should have the same discount rate. To make money, sell two
units of Asset C at a price of 200 and use the proceeds to purchase one unit of Asset D for 200.
The construction of the portfolio involves no net cash outlay today. Although it requires zero
dollars to construct today, the portfolio generates 10 one year from today. Asset D will generate
a 220 cash inflow, whereas the two units of Asset C sold will produce a cash outflow of 210.
Implications of Arbitrage-Free Valuation for Fixed-Income Securities
Using the arbitrage-free approach, any fixed-income security should be thought of as a package
or portfolio of zero-coupon bonds. Thus, a five-year 2% coupon Treasury issue should be viewed
as a package of 11 zero-coupon instruments (10 semiannual coupon payments, 1 of which is
made at maturity, and 1 principal value payment at maturity). The market mechanism for US
Treasuries that enables this approach is the dealer’s ability to separate the bond’s individual
cash flows and trade them as zero-coupon securities. This process is called stripping. In
addition, dealers can recombine the appropriate individual zero-coupon securities and
reproduce the underlying coupon Treasury. This process is called reconstitution.
The interest rates at each node in this interest rate tree are one-period forward rates
corresponding to the nodal period. Each forward rate is related to (i.e., is a multiple of) the other
forward rates in the same nodal period. Adjacent forward rates (at the same period) are two
standard deviations apart.

i = One-period forward rate

We denote iL to be the rate lower than the implied
forward rate and iH to be the higher forward rate.
The lognormal random walk posits the following
relationship between i1,L and i1,H:

SOLVE EX 3
from page 418
LOS 26.d: Describe the process of calibrating a binomial interest rate tree to match a
specific term structure.

The interest rate tree is generated using specialized computer software This means that the value
of bonds produced by the
Three rules to generate an interest rate tree: ·nterest rate tree must be
O Interest rate tree should generate arbitrage-free values equal to their market price,
which excludes arbitrage
8 Adjacent forward rates should be 2a apart opportunities
e Midpoint for each nodal period should be approximately equal to the
implied one-period forward rate

Backward induction refers to the process of valuing a bond using a binomial interest rate tree. The term
“backward” is used because in order to determine the value of a bond today at Node 0, you need to know
the values that the bond can take at the Year 1 node. But to determine the values of the bond at the Year 1
nodes, you need to know the possible values of the bond at the Year 2 nodes. Thus, for a bond that has N
compounding periods, the current value of the bond is determined by computing the bond’s possible values at
Period N and working backwards to Node 0.

Because the probabilities of an up move and a down move are both 50%, the value of a bond at a given
node in a binomial tree is the average of the present values of the two possible values from the next
period. The appropriate discount rate is the forward rate associated with the node.