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Bonds and Options in Exponentially Affine Bond Models

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  • Hans-Peter Bermin

Abstract

In this article we apply the Flesaker--Hughston approach to invert the yield curve and to price various options by letting the randomness in the economy be driven by a process closely related to the short rate, called the abstract short rate. This process is a pure deterministic translation of the short rate itself, and we use the deterministic shift to calibrate the models to the initial yield curve. We show that we can solve for the shift needed in closed form by transforming the problem to a new probability measure. Furthermore, when the abstract short rate follows a Cox--Ingersoll--Ross (CIR) process we compute bond option and swaption prices in closed form. We also propose a short-rate specification under the risk-neutral measure that allows the yield curve to be inverted and is consistent with the CIR dynamics for the abstract short rate, thus giving rise to closed form bond option and swaption prices.

Suggested Citation

  • Hans-Peter Bermin, 2012. "Bonds and Options in Exponentially Affine Bond Models," Applied Mathematical Finance, Taylor & Francis Journals, vol. 19(6), pages 513-534, December.
    • Handle: RePEc:taf:apmtfi:v:19:y:2012:i:6:p:513-534
    DOI: 10.1080/1350486X.2011.646505
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    References listed on IDEAS

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    1. Jamshidian, Farshid, 1989. " An Exact Bond Option Formula," Journal of Finance, American Finance Association, vol. 44(1), pages 205-209, March.
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    7. Hull, John & White, Alan, 1990. "Pricing Interest-Rate-Derivative Securities," Review of Financial Studies, Society for Financial Studies, vol. 3(4), pages 573-592.
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    Cited by:

    1. Hans-Peter Bermin & Gareth Williams, 2017. "On Cash Settled Irr-Swaptions And Markov Functional Modeling," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 20(02), pages 1-20, March.
    2. Mitra, Sovan & Date, Paresh & Mamon, Rogemar & Wang, I-Chieh, 2013. "Pricing and risk management of interest rate swaps," European Journal of Operational Research, Elsevier, vol. 228(1), pages 102-111.

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