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LOS 35.a: Explain what is meant by arbitrage-free READING 35: THE ARBITRAGE-FREE VALUATION FRAMEWORK
valuation of a fixed-income instrument.
MODULE 35.1: BINOMIAL TREES, PART 1
These models value securities under the assumption a riskless (arbitrage)
profit will dissipate to zero: 2 Types:
• Value additivity (value of whole differs from the sum of the values of parts -stripping or reconstitution occurs ); and
• Dominance (one asset trades at a lower price than another asset with identical characteristics).
EXAMPLE: The following info has been Value additivity principle:
collected:
Dominance principle:
Securities A and B are identical in every respect
other than as noted. Similarly, securities C and
D are identical in every other respect.
Demonstrate the exploitation of any
arbitrage opportunities.
