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Bond Price Dynamics and Options

Published online by Cambridge University Press:  01 December 2009

Clifford A. Ball  and
Walter N. Torous
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Extract

This paper provides a closed-form, preference-free means of valuing a European call option written on a default-free pure discount bond. Investors may not agree upon a theory of the term structure, but they will necessarily agree on equilibrium option values. Further, these equilibrium option values may be obtained without recourse to numerical approximation.

Default-free pure discount bond prices were posited to follow a non-standardized transformed Brownian bridge process. This specification implicitly incorporates the terminal constraint that the price of a default-free pure discount bond equal its face value at maturity.

Contingent claim valuation necessarily involves consideration of terminal constraints on the value of financial securities. The Brownian bridge specification permits an appropriate means of incorporating a number of such constraints. Therefore, while this paper has considered only the application of the Brownian bridge process to the valuation of debt options, the introduction of this process may provide for many further financial applications.

Type
Selected Papers from the 1983 Annual Conference
Information
Journal of Financial and Quantitative Analysis , Volume 18 , Issue 4 , December 1983 , pp. 517 - 531
Copyright
Copyright © School of Business Administration, University of Washington 1983

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References

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