LO 13.3: Describe uses and benefits o f the arbitrage-free models and assess the

LO 13.3: Describe uses and benefits o f the arbitrage-free models and assess the issue o f fitting models to market prices.
Broadly speaking, there are two types of models: arbitrage-free models and equilibrium models. The key factor in choosing between these two models is based on the need to match
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Topic 13 Cross Reference to GARP Assigned Reading – Tuckman, Chapter 9
market prices. Arbitrage models are often used to quote the prices of securities that are illiquid or customized. For example, an arbitrage-free tree is constructed to properly price on-the-run Treasury securities (i.e., the model price must match the market price). Then, the arbitrage-free tree is used to predict off-the-run Treasury securities and is compared to market prices to determine if the bonds are properly valued. These arbitrage models are also commonly used for pricing derivatives based on observable prices of the underlying security (e.g., options on bonds).
There are two potential detractors of arbitrage-free models. First, calibrating to market prices is still subject to the suitability of the original pricing model. For example, if the parallel shift assumption is not appropriate, then a better fitting model (by adding drift) will still be faulty. Second, arbitrage models assume the underlying prices are accurate. This will not be the case if there is an external, temporary, exogenous shock (e.g., oversupply of securities from forced liquidation, which temporarily depresses market prices).
If the purpose of the model is relative analysis (i.e., comparing the value of one security to another), then using arbitrage-free models, which assume both securities are properly priced, is meaningless. Hence, for relative analysis, equilibrium models would be used rather than arbitrage-free models.
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