Arbitrage with Fixed Costs and Interest Rate Models
In this paper, we study securities market models with fixed costs. We characterize the absence of arbitrage opportunities and we provide fair pricing rules. We then apply these results to extend some popular interest rate and option pricing models, which present arbitrage opportunities in the absence of fixed costs.In particular, we prove that the quite striking result obtained by Dybvig, Ingersoll and Ross (1996), which asserts that, under the assumption of absence of arbitrage, long zero-coupon rates can never fall, is no longer true in models with fixed costs, even arbitrarily small ones. For instance, models where the long-term rate follows a diffusion process are arbitrage-free in the presence of fixed costs (including arbitrarily small ones). We also rationalize models with partially absorbing or reflecting barriers on the price processes. In particular, we propose a version of the Cox, Ingersoll, and Ross (1985) model which, as in Longstaff (1992), produces yield curves with realistic humps but does not assume an absorbing barrier for the short-term rate. This is made possible by the presence of (even arbitrarily small) fixed costs.
|Date of creation:||01 Dec 2006|
|Date of revision:|
|Publication status:||Published in Journal of Financial and Quantitative Analysis, Cambridge University Press (CUP), 2006, pp.889-913|
|Note:||View the original document on HAL open archive server: https://halshs.archives-ouvertes.fr/halshs-00176496|
|Contact details of provider:|| Web page: https://hal.archives-ouvertes.fr/|
When requesting a correction, please mention this item's handle: RePEc:hal:journl:halshs-00176496. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (CCSD)
If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.
If references are entirely missing, you can add them using this form.
If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.
If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.
Please note that corrections may take a couple of weeks to filter through the various RePEc services.