THE ARBITRAGE-FREE VALUATION

FRAMEWORK
CHAPTER 8

2016 CFA Institute. All rights reserved.

TABLE OF CONTENTS
01 INTRODUCTION
02 THE MEANING OF ARBITRAGE-FREE VALUATION
03 INTEREST RATE TREES AND ARBITRAGE-FREE VALUATION
04 MONTE CARLO METHOD
05 SUMMARY

2
 1. INTRODUCTION
The idea that market prices will adjust until there are no
opportunities for arbitrage underpins the valuation of fixed-
income securities, derivatives, and other financial assets.
The purpose of this chapter is to develop a set of valuation
tools for bonds that are consistent with this notion.

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 2. THE MEANING OF ARBITRAGE-FREE
VALUATION
Arbitrage-free valuation refers to an approach to security
valuation that determines security values that are
consistent with the absence of arbitrage opportunities.

The traditional approach to valuing bonds is to discount all

cash flows with the same discount rate as if the yield curve
were flat.

However, the yield curve is rarely flat. Thus, each

cash flow of the bond should be discounted at the
appropriate spot rate. This leads to arbitrage-free
value.
Think of the valuation of a bond as a portfolio of
zeros.

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 ARBITRAGE OPPORTUNITIES
Arbitrage opportunities arise as a result of violations of the
law of one price.

There are two types

of arbitrage
opportunities.

Dominance, where a
Value additivity, which
financial asset with a risk-
means the value of the
free payoff in the future
whole equals the sum of
must have a positive price
the values of the parts
today

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 IMPLICATIONS OF ARBITRAGE-FREE
VALUATION
Using the arbitrage-free approach, any fixed-income
security should be thought of as a package or portfolio
of zero-coupon bonds.

Dealers in US Treasuries can separate

the bonds individual cash flows and
Stripping trade them as zero-coupon securities.
This process is called stripping.

Dealers can recombine the appropriate

individual zero-coupon securities and
Reconstitution reproduce the underlying coupon
Treasury. This process is called
reconstitution.

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 3. INTEREST RATE TREES AND
ARBITRAGE-FREE VALUATION
For option-free bonds, the simplest approach to arbitrage-
free valuation involves determining the arbitrage-free value
as the sum of the present values of expected future values
using the benchmark spot rates.
Benchmark securities are liquid, safe securities whose
yields serve as building blocks for other interest rates in a
particular country or currency.

General formula:

where z1, z2, zN are the spot rates for period 1, 2, and N.

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 OPTION-FREE VALUATION REFRESHER
Example. Assume an option-free bond with four years to
maturity and an annual coupon of 6.5%.
Year Spot Rate One-Year Forward
Rate
1 3.5000% 3.500%
2 4.215% 4.935%
3 4.735% 5.784%
4 5.271% 6.893%

+ +
+ +
+

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 DIFFERENT APPROACH FOR
BONDS WITH OPTIONS ATTACHED
For bonds with options attached, changes in future interest
rates impact the likelihood that the option will be exercised
and, in so doing, impact the cash flows.
The interest rate tree framework allows interest rates to
take on different potential values in the future based on
some assumed level of volatility.
The interest rate tree performs two functions in the
valuation process:

Generates the cash flows that are interest rate dependent

Supplies the interest rates used to determine the present value

of the cash flows

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BINOMIAL INTEREST RATE TREE FRAMEWORK
The binomial interest rate tree framework involves building
a binomial lattice model, where the short interest rate can
take on one of two possible values consistent with the
volatility assumption and an interest rate model.
A valuation model involves generating an interest rate tree
based on the following:

1 Benchmark interest rates

2 An assumed interest rate model

3 An assumed interest rate volatility

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 HOW TO OBTAIN VALUES FOR A
ONE-YEAR INTEREST RATE
To obtain the two possible values for the one-year interest
rate one year from today, two assumptions are required.
1 2
Interest rate volatility,
Interest rate model, which
represented by a standard
we assume to be
deviation measure in our
lognormal
modeling

The lognormal random walk posits the following relationship:

where i1, L = the rate lower than the implied forward rate at Time 1; i1,H =
the rate higher than the implied forward rate at Time 1; and is the
assumed volatility of the one-year rate.

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 BINOMIAL INTEREST RATE TREE

i3,HHH

i2,HH

i1,H i3,HHL
i0 i2,HL
i1,L i3,HLL

i2,LL

i3,LLL

Time 0 Time 1 Time 2 Time 3

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 ESTIMATING INTEREST RATE VOLATILITY

In estimating historical interest rate

volatility, volatility is calculated by
using data from the recent past with
the assumption that what has
happened recently is indicative of the
Two methods are future.
commonly used to
estimate interest rate
volatility. In the implied volatility approach,
the estimate interest rate volatility is
based on observed market prices of
interest rate derivatives (e.g.,
swaptions, caps, floors).

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 DETERMINING THE VALUE OF
A BOND AT A NODE
To find the value of the bond, the backward induction
valuation methodology can be used.
At maturity bonds are valued at par. So, we start at
maturity, fill in those values, and work back from right
to left to find the bonds value at the desired node.

Forward rateH Bond value if higher interest rate

is realized plus coupon payment
Bond value
at any node:
Bond value if lower interest rate is
Forward rateL realized plus coupon payment

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CALCULATING THE BOND VALUE AT ANY NODE

The bond value at a node is equal to the following:

where VH = the bonds value if the higher forward rate is

realized one year hence; VL = the bonds value if the lower
forward rate is realized one year hence; i = the one-year forward
rate at a particular node; and C = the coupon payment that is
not dependent on interest rates.

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 PRICING A BOND USING A BINOMIAL TREE
Example. Using the interest rate tree below, find the correct price
for a three-year, annual-pay bond with a coupon rate of 5%.

8.0%
5.0%

2.0% 6.0%

3.0%

4.0%

Time 0 Time 1 Time 2

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 PRICING A BOND USING A BINOMIAL TREE

Example (continued).
At Time 2, the bond value at each node is equal to the following:

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 PRICING A BOND USING A BINOMIAL TREE

Example (continued).
At Time 1, the bond value at each node is equal to the
following:

At Time 0, the bond value of the bond is

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 PRICING A BOND USING A BINOMIAL TREE
Example (continued).
C=5
8.0% V = 100

5.0% C=5
V = 102.2222
C=5
2.0% V = 103.2280 8.0% C=5
6.0% V = 100
V = 103.0287 5.0% C=5
V = 104.0566
C=5
3.0%
6.0% C=5
2.0% V = 106.9506 V = 100
4.0%
3.0% C=5
V = 105.9615 C=5
4.0% V = 100

Time 0 Time 1 Time 2 Time 3

C = cash flow (% of par); R = 1-year interest rate (%); V = value of bonds future cash flows (% of par)

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 CONSTRUCTING THE
BINOMIAL INTEREST RATE TREE
The construction of a binomial interest rate tree requires multiple
steps.
There are two potential changes in the forward rate at each node of
the binominal tree: higher rate and lower rate.
One of the forward rates (typically lower) can be found iteratively or
by solving simultaneous equations subject to using the following:

The relationship
Known (shorter)
Features of a coupon between a lower
spot and/or forward
bond of given maturity and higher rate and
rates
their volatility

Analytical tools, such as Solver in Excel, can help with the

calculations.

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 CALIBRATING A BINOMIAL TREE
To calibrate a binominal tree to match a specific term
structure, the following steps should be applied:
Finally,
using the
For a Then, for backward
known par an induction
Once
value yield assumed method,
completed,
curve, interest the values
the tree is
appropriate rate of the
calibrated
spot and volatility appropriate
to be
forward and model, zero-
arbitrage
rates can the interest coupon
free.
be rate tree is bonds at
estimated. built. each node
are
calculated.

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 VALUING AN OPTION-FREE BOND
WITH THE TREE
If two valuation methods are arbitrage free, they should
provide the same valuation result. Check using this process:

First: Second:

Calculate the Compare the

arbitrage-free pricing using
value of an the zero-
option-free, coupon yield
fixed-rate curve with the
coupon bond. pricing using an
arbitrage-free
binomial lattice.

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 VALUING AN OPTION-FREE BOND
WITH THE TREE

Example. Consider an option-free bond with three-

years remaining to maturity and a coupon rate of 5%.
Spot rates are the following:
Maturity Spot Rates
(years)
1 2.000%
2 3.015%
3 4.055%

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 VALUING AN OPTION-FREE BOND
WITH THE TREE
Example (continued).
The interest rate tree is as follows:
8.167%
4.646%

2.0% 6.051%

3.442%

4.482%

Time 0 Time 1 Time 2

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 VALUING AN OPTION-FREE BOND
WITH THE TREE
Example (continued).
C=5
8.167% V = 100

4.646% C=5
V = 102.0721
C=5
2.0% V = 103.4658 8.167% C=5
6.051% V = 100
V = 102.8101 4.646% C=5
V = 104.0090
C=5
3.442%
2.0% 6.051% C=5
V = 106.2668 V = 100
4.482%
3.442% C=5
V = 105.4958 C=5
4.482% V = 100

Time 0 Time 1 Time 2 Time 3

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 PATHWISE VALUATION
An alternative approach to backward induction in a
binomial tree is called pathwise valuation.
Pathwise valuation calculates the present value of a bond
for each possible interest rate path and takes the average
of these values across paths.
Pathwise valuation involves the following steps:

Specify a list of all potential paths through the tree.

Determine the present value of a bond along each potential

path.

Calculate the average across all possible paths.

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 PATHWISE VALUATION
Example. Consider the same option-free bond as on slide
23, with three years remaining to maturity and a coupon rate
of 5%.
There are four potential paths of interest rates: HH, HL, LH,
and LL. Using actual interest rates results in the following::
Path Time 0 Time 1 Time 2
1 2% 4.602% 8.167%
2 2% 4.602% 6.051%
3 2% 3.409% 6.051%
4 2% 3.409% 4.482%

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 PATHWISE VALUATION
Example (continued).

Present values: Path Time 0

1 100.5296

2 102.3449

3 103.4792

4 104.8876

Average 102.8103

The result is the same as calculated using the binominal tree and
spot rates.

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4. MONTE CARLO METHOD
The Monte Carlo method is an alternative method
for simulating a sufficiently large number of potential
interest rate paths in an effort to discover how a
value of a security is affected.

This method involves randomly selecting paths in

an effort to approximate the results of a complete
pathwise valuation.

Monte Carlo methods are often used when a

securitys cash flows are path dependent (e.g.,
asset-backed securities).

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 5. SUMMARY
Arbitrage-free valuation of a fixed-income
instrument
Using the arbitrage-free approach, viewing a security as a
package of zero-coupon bonds means that two bonds with
the same maturity and different coupon rates are viewed as
different packages of zero-coupon bonds and valued
accordingly.
For bonds that are option free, an arbitrage-free value is
simply the present value of expected future values using the
benchmark spot rates.

Binomial interest rate tree framework

A binomial interest rate tree permits the short interest rate to

take on one of two possible values consistent with the
volatility assumption and an interest rate model.

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SUMMARY

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SUMMARY

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