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January 25, 2005

Arbitrage Pricing

What determines the price of a given financial asset on a given day?


If the deposit/loan interest rate is 10% and a pure discount $1000 bond that matures in one year sells for $900, you can collect arbitrage profits by borrowing money to buy the bond.


You can collect the arbitrage profit immediately.


If the bond sells for $920, selling the bond and making a bank deposit produces aebitrage profits.


The bond yield is that interest rate that would eliminate the arbitrage profit. Firm belief that efficient markets eliminate such obvious arbitrage profits leads people to equate the bond yield with "the interest rate."


Posted by bparke at January 25, 2005 09:24 PM