A simple approach to bond option pricing

✍ Scribed by Wei, Jason Z.

• Publisher: John Wiley and Sons
• Year: 1997
• Tongue: English
• Weight: 335 KB
• Volume: 17
• Category: Article
• ISSN: 0270-7314
• DOI: 10.1002/(sici)1096-9934(199704)17:2<131::aid-fut1>3.0.co;2-k

✦ Synopsis

In the last 15 years or so, tremendous efforts and progress have been made in valuing interest rate sensitive derivative securities. Broadly speaking, two different approaches have been used. Some authors have modeled interest rates in an equilibrium setting and derived bond prices and other interest rate derivative securities prices based on the equilibrium movements of the underlying interest rates. Examples include Vasicek (1977) and . Others, pioneered by Ho and Lee (1986) and later generalized by authors such as Black, Derman, and Toy (1990); Hull and White (1990); and Heath, Jarrow, and Morton (1992); have developed models which describe the equilibrium movements of the whole term structure by taking the initial term structures as given. The two approaches differ mainly in that by construction in the second approach discount bonds are always correctly priced.

In both approaches, formulas for European options on discount bonds are given, except for Ho and Black, Derman, and Toy (1990) who developed a lattice framework. No attempt was made in any of these studies to derive closed-form formulas for European options on coupon-bonds, or for bond portfolios in general. Implicitly, however,