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The Direct Approach to Debt Option Pricing

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  • Rady, Sven

Abstract

We review the continuous{time literature on the so{called direct approach to bond option pricing. Going back to Ball and Torous (1983), this approach models bond price processes directly (i.e. without reference to interest rates or state variable processes) and applies methods that Black and Scholes (1973) and Merton (1973) had originally developed for stock options. We describe the principal modelling problems of the direct approach and compare in detail the solutions proposed in the literature

Suggested Citation

  • Rady, Sven, 1994. "The Direct Approach to Debt Option Pricing," Munich Reprints in Economics 3404, University of Munich, Department of Economics.
    • Handle: RePEc:lmu:muenar:3404
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    1. Harrison, J. Michael & Pliska, Stanley R., 1981. "Martingales and stochastic integrals in the theory of continuous trading," Stochastic Processes and their Applications, Elsevier, vol. 11(3), pages 215-260, August.
    2. Jamshidian, Farshid, 1989. " An Exact Bond Option Formula," Journal of Finance, American Finance Association, vol. 44(1), pages 205-209, March.
    3. Lo, Andrew W., 1988. "Maximum Likelihood Estimation of Generalized Itô Processes with Discretely Sampled Data," Econometric Theory, Cambridge University Press, vol. 4(2), pages 231-247, August.
    4. Robert C. Merton, 2005. "Theory of rational option pricing," World Scientific Book Chapters, in: Sudipto Bhattacharya & George M Constantinides (ed.), Theory Of Valuation, chapter 8, pages 229-288, World Scientific Publishing Co. Pte. Ltd..
    5. Schaefer, Stephen M & Schwartz, Eduardo S, 1987. "Time-Dependent Variance and the Pricing of Bond Options," Journal of Finance, American Finance Association, vol. 42(5), pages 1113-1128, December.
    6. Lo, Andrew W., 1986. "Statistical tests of contingent-claims asset-pricing models : A new methodology," Journal of Financial Economics, Elsevier, vol. 17(1), pages 143-173, September.
    7. Longstaff, Francis A & Schwartz, Eduardo S, 1992. "Interest Rate Volatility and the Term Structure: A Two-Factor General Equilibrium Model," Journal of Finance, American Finance Association, vol. 47(4), pages 1259-1282, September.
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    Cited by:

    1. Zühlsdorff, Christian, 2002. "The Pricing of Derivatives on Assets with Quadratic Volatility," Bonn Econ Discussion Papers 5/2002, University of Bonn, Bonn Graduate School of Economics (BGSE).
    2. Beniamin Goldys, 1997. "A note on pricing interest rate derivatives when forward LIBOR rates are lognormal," Finance and Stochastics, Springer, vol. 1(4), pages 345-352.
    3. Sven Rady, 1997. "Option pricing in the presence of natural boundaries and a quadratic diffusion term (*)," Finance and Stochastics, Springer, vol. 1(4), pages 331-344.
    4. Christian Zuhlsdorff, 2001. "The pricing of derivatives on assets with quadratic volatility," Applied Mathematical Finance, Taylor & Francis Journals, vol. 8(4), pages 235-262.
    5. Peter Carr & Travis Fisher & Johannes Ruf, 2012. "Why are quadratic normal volatility models analytically tractable?," Papers 1202.6187, arXiv.org, revised Mar 2013.
    6. Ioannides, Michalis, 2003. "A comparison of yield curve estimation techniques using UK data," Journal of Banking & Finance, Elsevier, vol. 27(1), pages 1-26, January.

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