The Arbitrage Free Valuation Framework

Question 1

What is arbitrage free valuation?

Answer 1

• determining the value of securities by assuming no arbitrage opportunity exists

Question 2

What is law of one price?

Answer 2

• law of one price: two goods that are perfect substitutes should have the same price. If different prices existed, trader could buy the cheaper one &sell the more expensive one to lock in a risk-free profit based on the price differential.

Question 3

What is the difference between stripping and reconstitution?

Answer 3

• stripping: 5 year annual coupon bond stripped into 6 components, 5 coupons and the principal payment
• reconstitution: purchase combination of zero coupon bonds that replicate cash flows of a coupon paying bond

Question 4

What is the difference between value additivity & dominance for the 2 types of arbitrage opportunities?

Answer 4

• value additivity: value of the whole can differ from the value obtained by adding the values of parts. (eg. the value of a bond could be less than the value of the sum of its individual cash flows)
• dominance: one security consistently offers a better yield than another security, despite both having the same characteristics, including the buying price