Estimation of the Local Volatility of Discount Bonds Using Market Quotes for Coupon-Bond Options

Hajime Fujiwara, Masaaki Kijima and Katsumasa Nishide
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Hajime Fujiwara: Nomura Securities Co., Ltd., Japan
Masaaki Kijima: Tokyo Metropolitan University/Kyoto University, Japan

Chapter 3 in Recent Advances in Financial Engineering, 2009, pp 49-69 from World Scientific Publishing Co. Pte. Ltd.

Abstract: AbstractThe key issue to price derivatives written on a coupon bond is the volatility structure, such as volatility smiles and skews, of the corresponding discount bonds, since the coupon bond is a portfolio of discount bonds. This paper proposes a method based on Dupire (1994) to estimate the local volatility of discount bonds when only the prices of coupon-bond options are observed in the market. Numerical examples show that our method can construct the local volatility structure of discount bonds that is consistent with the market data.

Keywords: Financial Engineering; Mathematical Finance; Real Options; Credit Risk; Option Pricing; Transaction Cost; Market Microstructure (search for similar items in EconPapers)
Date: 2009
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