In this chapter the concept of no-arbitrage will be discussed in the interest rate markets, which we also refer to as the bond market. Just to motivate the discussion, it should be noted that trading in various types of bonds grossly exceeds trading in the financial derivatives considered so far.
In Chapter 3, we considered pricing in complete (and incomplete) markets in discrete time and showed that the existence of a state price vector resulted in an arbitrage-free market. In Chapter 9, we presented a similar theory in continuous time and the tremendously important result was the correspondence between the existence and uniqueness of an equivalent martingale measure and arbitrage-free prices.
In the ...