Fixed Income Relative Value Analysis: A Practitioners Guide to the Theory, Tools, and Trades

Chapter 1

Relative Value

The Concept of Relative Value

Relative value is a quantitative analytical approach toward financial markets based on two fundamental notions of modern financial economics.

Proposition 1: If two securities have identical payoffs in every future state of the world, then they should have identical prices today.

Violation of this principle would result in the existence of an arbitrage opportunity, which is inconsistent with equilibrium in financial markets.

This proposition seems relatively straightforward now, but this wasn’t always the case. In fact, Kenneth Arrow and Gérard Debreu won Nobel prizes in economics in 1972 and 1983 in part for their work establishing this result. And Myron Scholes and Robert Merton later ...