BOND MATH: The Theory Behind the Formulas

Bond Prices and Yields to Maturity in a World of No Arbitrage

Modern financial theory of bond pricing rests on the principle of no arbitrage. Some call this the law of one price or, even more grandly, the fundamental theorem of finance. It essentially is a theory of relative prices—the idea is that if we observe prices on some fundamental building blocks, for instance, zero-coupon bonds, we can deduce the fair prices on coupon bonds that promise the same future cash flows. We don't try to figure out the demand and supply for each bond in the marketplace. Instead we observe the market prices on the most actively traded securities and value the remainder assuming arbitrage opportunities are exploited and priced away.

No-arbitrage pricing is a powerful ...