Sequential Arbitrage Measurements and Interest Rate Envelopes Articles uri icon

publication date

  • September 2008

start page

  • 361

end page

  • 374

issue

  • 3

volume

  • 138

International Standard Serial Number (ISSN)

  • 0022-3239

Electronic International Standard Serial Number (EISSN)

  • 1573-2878

abstract

  • This paper proposes new measures that provide us with the level of sequential arbitrage in bond markets. All the measures vanish in an arbitrage-free market and all of them are positive otherwise. Each measure is generated by a dual pair of optimization problems. Primal problems permit us to compute optimal sequential arbitrage strategies, if available. Each dual problem generates a concrete proxy for the term structure of interest rates. The set of proxies allows us to obtain the exact market price of any bond and may measure several effects. For instance, the credit risk spread of nondefault free bonds, or the embedded option price of callable or extendible bonds. The developed theory has been tested empirically.