Interest Rates as Options

J. OF FINANCE, Vol. 50 No. 5, December 1995

Posted: 15 Jul 1998

See all articles by Fischer Black

Fischer Black

Sloan School of Management, MIT (Deceased)

Abstract

Since people can hold currency at a zero nominal interest rate, the nominal short rate cannot be negative. The real interest rate can be and has been negative, since low risk real investment opportunities, like filling in the Mississippi delta, do not guarantee positive returns. The inflation rate can be and has been negative, most recently (in the U.S.) during the Great Depression. The nominal short rate is the "shadow real interest rate" (as defined by the investment opportunity set) plus the inflation rate, or zero, whichever is greater. Thus the nominal short rate is an option. Longer term interest rates are always positive, since the future short rate may be positive even when the current short rate is zero. We can easily build this option element into our interest rate trees for backward induction or Monte Carlo simulation: just create a distribution that allows negative nominal rates, and then replace each negative rate with zero.

JEL Classification: E47, C15

Suggested Citation

Black, Fischer, Interest Rates as Options. J. OF FINANCE, Vol. 50 No. 5, December 1995, Available at SSRN: https://ssrn.com/abstract=7012

Fischer Black (Contact Author)

Sloan School of Management, MIT (Deceased)

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