Pricing and Hedging Discount Bond Options in the Presence of Model Risk

Posted: 4 May 2001

See all articles by Francois Lhabitant

Francois Lhabitant

Kedge Capital Fund Management; EDHEC Business School

Claude Martini

Institut National de Recherche en Informatique et Automatique (INRIA)

A. Reghai

Institut National de Recherche en Informatique et Automatique (INRIA)

Abstract

This paper focuses on pricing and hedging options on a zero-coupon bond in a Heath?Jarrow?Morton (1992) framework when the value and/or functional form of forward interest rates volatility is unknown, but is assumed to lie between two fixed values. Due to the link existing between the drift and the diffusion coefficients of the forward rates in the Heath, Jarrow and Morton framework, this is equivalent to hedging and pricing the option when the underlying interest rate model is unknown. We show that a continuous range of option prices consistent with no arbitrage exist. This range is bounded by the smallest upper-hedging strategy and the largest lower-hedging strategy prices, which are characterized as the solutions of two non-linear partial differential equations. We also discuss several pricing and hedging illustrations.

Suggested Citation

Lhabitant, Francois-Serge and Martini, Claude and Reghai, A., Pricing and Hedging Discount Bond Options in the Presence of Model Risk. European Finance Review, Vol. 4, No. 1, 2001. Available at SSRN: https://ssrn.com/abstract=264300

Francois-Serge Lhabitant (Contact Author)

Kedge Capital Fund Management ( email )

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St Helier, JE1 1ZZ
Jersey

HOME PAGE: http://www.lhabitant.net

EDHEC Business School ( email )

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Nice, 06200
France

Claude Martini

Institut National de Recherche en Informatique et Automatique (INRIA) ( email )

40 avenue Halley
Villeneuve, 59650
France

A. Reghai

Institut National de Recherche en Informatique et Automatique (INRIA)

40 avenue Halley
Villeneuve, 59650
France

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