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Time-Dependent Variance and the Pricing of Bond Options

Stephen M. Schaefer and Eduardo S. Schwartz
The Journal of Finance
Vol. 42, No. 5 (Dec., 1987), pp. 1113-1128
Published by: Wiley for the American Finance Association
DOI: 10.2307/2328517
Stable URL: http://www.jstor.org/stable/2328517
Page Count: 16
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Time-Dependent Variance and the Pricing of Bond Options
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Abstract

In this paper, we develop a model for valuing debt options that takes into account the changing characteristics of the underlying bond by assuming that the standard deviation of return is proportional to the bond's duration. The resulting model uses the bond price as the single state variable and thus preserves much of the simplicity and robustness of the Black-Scholes approach. The paper provides comparisons between option prices computed using this model and those using the Black-Scholes and Brennan and Schwartz models.

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