Level II - Fixed Income: Valuation Concepts

The Arbitrage Free Valuation Model

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 Contents and Introduction

1. Introduction

2. The Meaning of Arbitrage-Free Valuation

3. Interest Rate Trees and Arbitrage-Free Valuation

4. Monte Carlo Method

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 2. The Meaning of Arbitrage-Free Valuation
• Arbitrage: earn riskless profits without any net investment of money

• In well-functioning markets, prices adjust until there are no arbitrage opportunities

• Arbitrage-free valuation: approach to security valuation that determines security values that are
consistent with the absence of arbitrage opportunities

• The value of any financial asset is equal to the present value of its expected future cash flows

2.1. The Law of One Price

Arbitrage opportunities arise as a result of 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 costs.

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 2.2. Arbitrage Opportunity
An arbitrage opportunity is a transaction that involves no cash outlay yet results in a riskless profit.

Asset A is a risk-free zero-coupon bond that pays off one dollar and is priced today at 0.952381 ($1/1.05).
Asset B is a portfolio of 105 units of Asset A that pays off $105 one year from today and is priced today at $95.

Value additivity arbitrage opportunity:

Asset Price Today Payoff in One Year
The portfolio does not equal the sum of the parts.
A $0.952381 $1
B $95 $105 Sell 105 units of Asset A for 105 × $0.952381 = $100
Buy one portfolio Asset B for $95.

C and D are risk-free assets.

Dominance arbitrage opportunity:
Asset Price Today Payoff in One Year Two risk-free assets should have the same return but in this
C $100 $105 case they don’t.
D $200 $220
Sell two units of Asset C at a price of $200
Buy one unit of Asset D for $200

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 Example 1: Arbitrage Opportunities
Which of the following investment alternatives includes an arbitrage opportunity?
• Bond A: The yield for a 3% coupon 10-year annual-pay bond is 2.5% in New York City. The same
bond sells for $104.376 per $100 face value in Chicago.
• Bond B: The yield for a 3% coupon 10-year annual-pay bond is 3.2% in Hong Kong. The same bond
sells for RMB97.220 per RMB100 face value in Shanghai.

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 2.3. 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.

• Two bonds with the same maturity and different coupon rates are viewed as different packages of
zero-coupon bonds and valued accordingly.

• For bonds that are option free, an arbitrage-free value is simply the present value of expected
future values using the benchmark spot rates.

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 3. Interest Rate Trees and Arbitrage-Free Valuation

1. The Binomial Interest Rate Tree

2. What Is Volatility and How Is It Estimated?

3. Determining the Value of a Bond at a Node

4. Constructing the Binomial Interest Rate Tree

5. Valuing an Option-Free Bond with the Tree

6. Pathwise Valuation

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 3.1. Binomial Interest Rate Tree
An interest rate tree is a visual representation of the possible values of interest rates (forward rates) based on
an interest rate model and an assumption about interest rate volatility.

The possible interest rates for any following period

are consistent with the following three assumptions:
1. an interest rate model that governs the random
process of interest rates
2. the assumed level of interest rate volatility
3. the current benchmark yield curve.

Lognormal model of interest rates means:

• adjacent interest rates on the tree are
multiples of e2σ
• interest rates cannot be negative
• higher volatility at higher interest rates

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 3.2. What Is Volatility and How Is It Estimated?
• With a simple lognormal distribution, the changes in interest rates are proportional
to the level of the one-period interest rates each period.

• The standard deviation of the one-year rate is equal to i0σ

• There are two methods commonly used to estimate interest rate volatility:
 Historical method
 Implied volatility

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 3.3. Determining the Value of a Bond at a Node
Backward Induction: start at maturity, fill in those values, and work back from right to left to
find the bond’s value at the desired node.

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 Example 3: Pricing a Bond Using a Binomial Tree
Using the interest rate tree below, find the correct price for a three-year, annual-pay bond with a coupon rate of 5%.

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 3.4. Constructing the Binomial Interest Rate Tree
The interest rate tree is fit to the current yield curve by choosing interest rates that result in the
benchmark bond value. By doing this, the bond value is arbitrage free.

1. Determine forward rates

2. Given a forward rate and a

volatility assumption determine
the high and low rates

3. Check if these rates result in the

benchmark bond value

4. If not, make adjustments to rates

until you get the benchmark bond
value

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 Example 4: Calibrating a Binomial Tree to Match a
Specific Term Structure
The one-year par rate is 2.0%, the two-year par rate is 3.0%, and the three-year par rate is 4.0%. Consequently, the
spot rates are S1 = 2.0%, S2 = 3.015% and S3 = 4.055%. Zero-coupon bond prices are P1 = 1/1.020 = 0.9804, P2 =
1/(1.03015)2 = 0.9423, and P3 = 1/(1.04055)3 = 0.8876. Interest volatility is 15% for all years. Calibrate the binomial
tree shown below:

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 Example 4: (Cont…)
The one-year par rate is 2.0%, the two-year par rate is 3.0%, and the three-year par rate is 4.0%. Consequently, the
spot rates are S1 = 2.0%, S2 = 3.015% and S3 = 4.055%. Zero-coupon bond prices are P1 = 1/1.020 = 0.9804, P2 =
1/(1.03015)2 = 0.9423, and P3 = 1/(1.04055)3 = 0.8876. Interest volatility is 15% for all years.

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3.5. Valuing an Option-Free Bond with the Tree

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Example 5: Confirming the Arbitrage-Free Value of a Bond
The yield to maturity for a one-year annual-pay bond is 2%, for a two-year annual-pay bond is 3%, and for a three-
year annual-pay bond is 4%. Let us use a three-year annual-pay bond with a 5% coupon. We know that if the
calibrated tree was built correctly and we perform calculations to value the bond with that tree its price should be
$102.8102.

Example 2: Using spot rates:

P0 = 5/1.02 + 5/1.030152 + 105/1.040553

= $102.8102

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 3.6. Pathwise Valuation
Pathwise valuation calculates the present value of a bond for each possible interest rate path and
takes the average of these values across paths. The steps:
1. specify a list of all potential paths through the tree
2. determine the present value of a bond along each potential path
3. calculate the average across all possible paths

Four Interest Rate Paths for a Three-Year Zero-Coupon Bond

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 Example 6: Pathwise Valuation
Using the par curve from Example 2, Example 4, and Example 5, the yield to maturity for a one-year
annual-pay bond is 2%, for a two-year annual-pay bond is 3%, and for a three-year annual-pay bond is
4%. We know that if we generate the paths in the tree correctly and discount the cash flows directly,
the three-year, annual-pay, 5% coupon bond should still be priced at $102.8102.

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 4. Monte Carlo Method
• Monte Carlo methods are often used when a security’s cash flows are path dependent.
• The Monte Carlo method involves randomly selecting paths in an effort to approximate the results of
a complete pathwise valuation.
• Suppose we intend to value a 30-year bond with the Monte Carlo method. For simplicity, assume the
bond has monthly coupon payments (e.g., mortgage-backed securities). The following steps are
taken: (1) simulate numerous (say, 500) paths of one-month interest rates under some volatility
assumption and probability distribution, (2) generate spot rates from the simulated future one-
month interest rates, (3) determine the cash flow along each interest rate path, (4) calculate the
present value for each path, and (5) calculate the average present value across all interest rate paths.
• A constant is added to all interest rates on all paths such that the average present value for each
benchmark bond equals its market value. The constant added to all short interest rates is called a
drift term. When this technique is used, the model is said to be drift adjusted.
• The Monte Carlo method is only as good as the valuation model used and the accuracy of the inputs.
• Consider mean reversion.

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 Summary

• The Meaning of Arbitrage-Free Valuation

• Interest Rate Trees and Arbitrage-Free Valuation

• Monte Carlo Method

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 Conclusion
• Learning outcomes

• Summary

• Examples

• Practice problems

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