January 23, 2004
Arbitrage Pricing
An arbitrage profit is (1) risk-free and (2) requires none of your own money. Thinking about potential arbitrage profits provides a basis for pricing bonds according to the discounted present values of their income streams.
If the bond price is below 909.09, there are arbitrage profits to be gained by borrowing money to buy the bond.
If the bond price is above 909.09, there are arbitrage profits to be gained by selling the bond and depositing the proceeds in the bank.
We can extend this analysis to a bond that matures in two years.
