Price Bounds on Bond Options, Swaptions, Caps, and Floors Assuming Only Nonnegative Interest Rates
Posted: 15 Dec 2002
This paper derives bounds on the prices of European and American bond options, caps, floors, and European swaptions assuming only absence of arbitrage and non-negative interest rates. The bounds are considerably tighter than Merton's bounds on stock option prices, especially for options on short-term bonds or swaps and short-term caps and floors. For American bond options it is important to distinguish between options on the quoted ("clean") bond price and options on the true ("dirty") bond price. For example, it is shown that it may be optimal to exercise an American call on the quoted bond price early even if the underlying bond makes no payments in the remaining life of the option.
Keywords: Interest rate options, no-arbitrage price bounds, non-negative interest rates
JEL Classification: G13, E43
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