The Pricing of Default-free Interest Rate Cap, Floor, and Collar Agreements

Authors

  • ERIC BRIYS,

  • MICHEL CROUHY,

  • RAINER SCHÖBEL

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    • Briys and Crouhy are from Groupe HEC, 78351 Jouy en Josas, France, and Schöbel is from Universität Lüneburg, 2120 Lüneburg, Federal Republic of Germany. The authors gratefully acknowledge helpful comments on earlier drafts by Suresh Sundaresan and an anonymous referee. The paper has also benefited from stimulating discussions with many of our colleagues at seminars and conversations, especially those with Dan Galai, Myron Scholes, Eduardo Schwartz, and Lee Wakeman. Of course, the authors are solely responsible for any remaining errors.

ABSTRACT

The paper focuses on the valuation of caps, floors, and collars in a contingent claim framework under continuous time. These instruments are interpreted as options on traded zero coupon bonds. The bond prices themselves are used as the underlying stochastic variables. This has the advantage that we end up with closed form solutions which are easy to compute. Special attention is devoted to the choice of the stochastic process appropriate for the price dynamics of the underlying zero coupon bonds.

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