LOS
67
.f. explain the arbitrage-free valuation approach and the market process that forces
the price of a bond toward its arbitrage-free value, and explain how a dealer can
generate an arbitrage profit if a bond is mispriced.
The value of the bond based on the spot rates is the arbitrage-free value.
How Does a Dealer Generate Arbitrage Profits?
A dealer has the ability to strip a security or to take apart the cash flows that make up the bond and create new securites out of them. These Treasury strips can be sold to investors. So if the market price of a Treasury security is less than the value using the arbitrage-free valuation, a dealer will buy the security, strip the bond (break the bond into strips) and then sell the Treasury strips at a higher amount than the purchase price for the whole bond.
See for more
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa37.asp
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