The Survival Zone for a Bond with Both Call and Put Options Embedded
George Washington University - Department of Finance
University of Cyprus - Department of Public and Business Administration; George Washington University - School of Business
Journal of Financial Research
We present a numerical method to price bonds that have multiple embedded options with an emphasis on the case with both long call and short put options. The valuation framework is a one-factor model for the term structure of interest rates where the instantaneous interest rate is allowed to follow a fairly general stochastic process. The equilibrium interest rates that define the free boundaries for the embedded call and put options are given. We demonstrate the survival zone within which a bond with both long call and short put options remains afloat. We show that even moderate levels of transaction costs can have a significant effect on exercise of options.
JEL Classification: G13, G12Accepted Paper Series
Date posted: September 14, 1998
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