ABSTRACT
This chapter presents the theory underlying the example presented in Chapter 8. The purpose of this chapter, as well as the last, is to investigate the existence of arbitrage opportunities within the yield curve. Taken as given are the current market prices and the stochastic processes for a few zero-coupon bonds and the spot rate of interest. The theory determines a “fair” or arbitrage-free price for the remaining zero-coupon bonds. This is the modern analog of arbitraging the yield curve.
