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THE SURVIVAL ZONE FOR A BOND WITH BOTH CALL AND PUT OPTIONS EMBEDDED
Author(s) -
Martzoukos Spiros H.,
Barnhill Theodore M.
Publication year - 1998
Publication title -
journal of financial research
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.319
H-Index - 49
eISSN - 1475-6803
pISSN - 0270-2592
DOI - 10.1111/j.1475-6803.1998.tb00695.x
Subject(s) - interest rate , valuation (finance) , embedded option , bond , transaction cost , database transaction , call option , term (time) , bond valuation , actuarial science , computer science , economics , econometrics , monetary economics , finance , programming language , physics , quantum mechanics
We present a numerical method to price bonds that have multiple embedded options with an emphasis on the case with both long call and short put options. The valuation framework is a one‐factor model for the term structure of interest rates, where the instantaneous interest rate is allowed to follow a fairly general stochastic process. The equilibrium interest rates that define the free boundaries for the embedded call and put options are given. We demonstrate the survival zone within which a bond with both long call and short put options remains afloat. We show that even moderate levels of transaction costs can have a significant effect on exercise of options.