Time-Dependent Variance and the Pricing of Bond Options

Authors

  • STEPHEN M. SCHAEFER,

  • EDUARDO S. SCHWARTZ

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    • London Business School and University of California, Los Angeles, respectively. This paper was written during the period that Stephen M. Schaefer spent at the Faculty of Commerce and Business Administration of the University of British Columbia as the Leslie Wong Summer Visitor. He is very grateful to the Faculty at UBC for their generous invitation and their warm hospitality. The authors are most grateful to Hoare Govett and Company, London, for providing the data used in this study and to Walter Torous and Mark Rubinstein (the referee) for helpful comments.

ABSTRACT

In this paper, we develop a model for valuing debt options that takes into account the changing characteristics of the underlying bond by assuming that the standard deviation of return is proportional to the bond's duration. The resulting model uses the bond price as the single state variable and thus preserves much of the simplicity and robustness of the Black-Scholes approach. The paper provides comparisons between option prices computed using this model and those using the Black-Scholes and Brennan and Schwartz models.

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