Advanced Search
MyIDEAS: Login

Credit Spread Specification and the Pricing of Spread Options

Contents:

Author Info

  • Nicolas Mougeot

    (FAME and Institute of Banking and Financial Management, Ecole des HEC)

Registered author(s):

    Abstract

    This paper presents a simple approach to the pricing of options on spread and some arguments in favor of modelling the spread using its two components instead of the spread itself. We show that, even in a simple Gaussian setting, the spread should not be modelled directly, and that convergence speeds of the two components are crucial parameters. There exist conditions, discussed in this paper, under which the analysis can be reduced to a two-factor model based on the dynamics of the spread itself. Hence, we propose a three-factor model based on the dynamics of the riskless rate and of the two components of the spread. This is done by following the Longstaff (1990) methodology and with the assumption that both the riskless rate and the spread or its two components follow correlated Ornstein-Uhlenbeck processes. Greeks analysis shows that spread options have some very specific features compared to the Black-Scholes-Merton (1973) option model. Moreover, the results show that the mispricing is important and not systematic when one chooses a spread option model based on the dynamics of the spread instead of using the dynamics of its two components. We finally show how the spread option model allows us to price other yield derivatives, like options to exchange a yield for another or the options on the maximum or the minimum of two yields.

    Download Info

    If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
    File URL: http://www.swissfinanceinstitute.ch/rp14.pdf
    Download Restriction: no

    Bibliographic Info

    Paper provided by International Center for Financial Asset Management and Engineering in its series FAME Research Paper Series with number rp14.

    as in new window
    Length:
    Date of creation:
    Date of revision:
    Handle: RePEc:fam:rpseri:rp14

    Contact details of provider:
    Postal: 40 bd. du Pont d'Arve, Case postale 3, CH - 1211 Geneva 4
    Phone: 41 22 / 312 09 61
    Fax: 41 22 / 312 10 26
    Web page: http://www.swissfinanceinstitute.ch
    More information through EDIRC

    Related research

    Keywords: Credit spread; Option valuation; Change of probability measure;

    Find related papers by JEL classification:

    This paper has been announced in the following NEP Reports:

    References

    References listed on IDEAS
    Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
    as in new window
    1. Longstaff, Francis A., 1990. "The valuation of options on yields," Journal of Financial Economics, Elsevier, vol. 26(1), pages 97-121, July.
    2. Robert C. Merton, 1973. "Theory of Rational Option Pricing," Bell Journal of Economics, The RAND Corporation, vol. 4(1), pages 141-183, Spring.
    3. Hull, John & White, Alan, 1990. "Pricing Interest-Rate-Derivative Securities," Review of Financial Studies, Society for Financial Studies, vol. 3(4), pages 573-92.
    4. Black, Fischer, 1976. "The pricing of commodity contracts," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 167-179.
    5. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
    6. Vasicek, Oldrich Alfonso, 1977. "Abstract: An Equilibrium Characterization of the Term Structure," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 12(04), pages 627-627, November.
    7. Vasicek, Oldrich, 1977. "An equilibrium characterization of the term structure," Journal of Financial Economics, Elsevier, vol. 5(2), pages 177-188, November.
    8. Margrabe, William, 1978. "The Value of an Option to Exchange One Asset for Another," Journal of Finance, American Finance Association, vol. 33(1), pages 177-86, March.
    Full references (including those not matched with items on IDEAS)

    Citations

    Lists

    This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

    Statistics

    Access and download statistics

    Corrections

    When requesting a correction, please mention this item's handle: RePEc:fam:rpseri:rp14. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Marilyn Barja).

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If references are entirely missing, you can add them using this form.

    If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.