Equilibrium models versus fitting today's prices
Question
How does the equilibrium approach to modelling differ from the no-arbitrage approach?
Short answer
Equilibrium models derive prices from assumed economics (investor preferences, dynamics of state variables), while no-arbitrage models take some current market prices as given and price other instruments consistently with them. Vasicek and CIR are equilibrium short-rate models that need not fit today's yield curve; Ho-Lee and Hull-White add time-dependent parameters to fit it exactly. Equilibrium gives economic insight; no-arbitrage gives relative-value consistency for trading.
Adapted from Wilmott, Frequently Asked Questions in Quantitative Finance, FAQ 43, p.198; question and answer rewritten by SelfMadeQuant.com.
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- Expectations, Volatility, and the Shape of the Term Structure
- Exponential Growth, Decay, and Continuous Compounding
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