Arbitrage-free valuation approach, Financial Management

The main drawback of the tradition approach of valuation is that it discounts every cash flow using the same discount rate. For example, let us take 5-year (7.00 per cent) Treasury security (maturing in 2010). The cash flow per Rs.100 of par value would be a payment of Rs.3.50 every six months and Rs.103.50 tenth 6-month period from now.  However, the best way to see the 5-year 7% security is as a package of zero-coupon bonds whose maturity value and date is the amount and date of cash flow respectively. Thus, 5-year, 7% security should be viewed as 10 zero-coupon bond. The main reason is that it does not allow a market participant to realize an arbitrage profit by taking apart or "stripping" a security and selling off the stripped securities at a higher aggregate value it would cost to purchase the security in the market. This approach is known as an arbitrage-free valuation approach.

The difference between the traditional and arbitrage-free valuation approach is explained in the table 5. 

Table 1: Comparison of Traditional Approach and
Arbitrage-Free Valuation Approach in 7% Treasury Security

Period
(6 month each)

Discount (Base Interest) Rate

Cash Flows per Rs. 100 of par value

Traditional Approach

Arbitrage-Free Valuation Approach

    1

5-year Treasury rate

  1-period Treasury spot rate

   3.5

  2

5-year Treasury rate

  2-period Treasury spot rate

   3.5

  3

5-year Treasury rate

  3-period Treasury spot rate

   3.5

  4

5-year Treasury rate

  4-period Treasury spot rate

   3.5

  5

5-year Treasury rate

  5-period Treasury spot rate

   3.5

  6

5-year Treasury rate

  6-period Treasury spot rate

   3.5

  7

5-year Treasury rate

  7-period Treasury spot rate

   3.5

  8

5-year Treasury rate

  8-period Treasury spot rate

   3.5

  9

5-year Treasury rate

  9-period Treasury spot rate

   3.5

10

5-year Treasury rate

10-period Treasury spot rate

103.5                              

Under traditional approach interest rate on the bond is the yield of 5-year treasury security. In arbitrage-free approach the interest rate for a cash flow is the theoretical rate that the treasury security has to pay if it issued as a zero-coupon bond with maturity date equal to the maturity date of the cash flow. So, it is necessary to decide the theoretical rate that the treasury security has to pay on a zero coupon for each maturity. Zero-coupon treasury rate is also known as 'Treasury Spot Rate'. In the next chapter, we will understand how to calculate the treasury spot rate. When the value of a bond is calculated based on spot rate, the resulting value is known as arbitrage-free value.

Posted Date: 9/10/2012 6:08:20 AM | Location : United States







Related Discussions:- Arbitrage-free valuation approach, Assignment Help, Ask Question on Arbitrage-free valuation approach, Get Answer, Expert's Help, Arbitrage-free valuation approach Discussions

Write discussion on Arbitrage-free valuation approach
Your posts are moderated
Related Questions
2.5. Västerås Corporation plans to buy a truck for $40,000 and depreciate it fully over 5 years using straight-line method of depreciation. However, it plans to use it for 8 years

Discuss risk from the perspective of the Capital Asset Pricing Model (CAPM). The Capital Asset Pricing Model, or also known as CAPM, can be employed to calculate the suitable req

Accounting Framework - Convention of Conservation Conservatism refers to the principle and practices that are established through way of tradition, reluctance to change from e

Question: (a) A stock currently sells for $80 and a put option with an exercise price of $80 currently sells for $2. Find the percentage gain to an investor in the common stock

Q. Benefits of Interest rate swaps? Interest rate swaps may provide several benefits to companies including: - The ability to get finance at a cheaper cost than would be p

Evaluation of money-market hedge Expected receipt after 3 months = $300000 Dollar interest rate over three months = 5.4/ 4 = 1.35% Dollars to borrow now to have $300000 l

Q. Equity Method of Accounting? Equity Method of Accounting - Investors cost basis is adjusted up or down (according to the % of stock ownership) as investee's retained earning

The earnings per share of a company is Rs 8 and the rate of capitalization applicable is 10%. The company has before it, an option of adopting i) 50,ii) 75 iii) 100 per cent div

Audit risk Obtain understanding of accounting and internal control systems. Sufficient to plan audit and develop effective audit approach. Professional judgement to

The authority and duties of members (shareholders) Members and shareholders shall together and severally protect, conserve and actively exercise the supreme authority of the co