A Bayesian Approach to the Empirical Valuation of Bond Options

Abstract

In this paper we propose and implement a Bayesian procedure for the empirical valuation of bond options given the observed term structure of interest rates, and given assumptions about the time series behavior of the instantaneous spot rate. The Bayesian approach is motivated by some empirical problems that arise if the implied volatility is estimated directly by cross sectional fitting of the yield curve. The proposed method is applied to a dataset of Dutch bond prices.

JEL Classification: F30