ABSTRACT
This chapter shows how to use the concepts of trading strategies, arbitrage opportunities, and complete markets to investigate mispricings within the yield curve. There are two equivalent methods for determining the “fair” or arbitrage-free prices of the desired zero-coupon bonds. The first method concentrates on a technique for constructing the zero-coupon bond synthetically, using the money market account and the 4-period zero. The second method uses an elegant theory to derive a present value operator – the technique is called risk-neutral valuation. It is important to note that the value for the 2-period zero-coupon bond does not depend on the actual probabilities for the evolution of the 4-period zero-coupon bond and the money market account. The risk-neutral valuation approach proceeds by determining a present value operator that can be used to value the 2- and 3-period zero-coupon bonds.
