A Simple Approach to Bond Option Pricing
Jason Zhanshun Wei
University of Toronto - Rotman School of Management
Many authors have derived closed-form formulas for European options on discount bonds within a one-factor interest rate framework. The only known formula for European options on coupon-paying bonds is given by Jamshidian (1989), which is in the form of a portfolio of options on discount bonds. Not only does this approach require pricing of more than one options, it also requires that a threshold interest rate level be solved iteratively. When there are many coupons or when pricing is needed more frequently, Jamshidian's approach can be costly. In this paper, we show a very simple approach to pricing European options on bond portfolios. We not only do away with the requirement of calculating iteratively the threshold level of interest rate, but also reduce the calculation to only one option price. It also dramatically simplifies hedging. The key of this approach is to use a single discount bond to approximate the bond portfolio by matching durations.
JEL Classification: G13working papers series
Date posted: December 30, 1998
© 2013 Social Science Electronic Publishing, Inc. All Rights Reserved.
This page was processed by apollo5 in 0.453 seconds