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Sequential Arbitrage Measurements and Interest Rate Envelopes

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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.

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Authors and Affiliations

  1. University Carlos III of Madrid, Calle Madrid 126, 28903, Getafe, Madrid, Spain

    A. Balbás

  2. Department of Economic Analysis: Quantitative Economics, Autonomous University of Madrid, Calle Tomás y Valiente, 5, 28049, Canto Blanco, Madrid, Spain

    S. López

Authors
  1. A. Balbás
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  2. S. López
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Corresponding author

Correspondence to A. Balbás.

Additional information

Research partially supported by Welzia Management SGIIC, RD_Sistemas, Comunidad Autónoma de Madrid (Spain), Grant s-0505/tic/000230, and MEyC (Spain), Grant SEJ2006-15401-C04-03. The authors thank Elizabeth Cabrera (Arizona State University), Alfredo Ibáñez (ITAM-Mexico), Alfonso Novales (Complutense University, Madrid) and the reviewers for helpful comments.

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Balbás, A., López, S. Sequential Arbitrage Measurements and Interest Rate Envelopes. J Optim Theory Appl 138, 361–374 (2008). https://doi.org/10.1007/s10957-008-9391-5

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  • DOI: https://doi.org/10.1007/s10957-008-9391-5

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