Pricing and Hedging Bond Power Exchange Options in a Stochastic String Term-Structure Model

Lloyd P. Blenman, Alberto Bueno-Guerrero and Steven P. Clark
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Lloyd P. Blenman: Department of Finance, University of North Carolina at Charlotte, 9201 University City Blvd, Charlotte, NC 28223, USA
Alberto Bueno-Guerrero: Department of Economics, IES Francisco Ayala, 18014 Granada, Spain
Steven P. Clark: Department of Finance, University of North Carolina at Charlotte, 9201 University City Blvd, Charlotte, NC 28223, USA

Risks, 2022, vol. 10, issue 10, 1-17

Abstract: We study power exchange options written on zero-coupon bonds under a stochastic string term-structure framework. Closed-form expressions for pricing and hedging bond power exchange options are obtained and, as particular cases, the corresponding expressions for call power options and constant underlying elasticity in strikes (CUES) options. Sufficient conditions for the equivalence of the European and the American versions of bond power exchange options are provided and the put-call parity relation for European bond power exchange options is established. Finally, we consider several applications of our results including duration and convexity measures for bond power exchange options, pricing extendable/accelerable maturity zero-coupon bonds, options to price a zero-coupon bond off of a shifted term-structure, and options on interest rates and rate spreads. In particular, we show that standard formulas for interest rate caplets and floorlets in a LIBOR market model can be obtained as special cases of bond power exchange options under a stochastic string term-structure model.

Keywords: stochastic string process; term-structure model; bond option pricing; Malliavin calculus (search for similar items in EconPapers)
JEL-codes: C G0 G1 G2 G3 K2 M2 M4 (search for similar items in EconPapers)
Date: 2022
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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