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Pricing Interest Rate Options in a Two-Factor Cox--Ingersoll--Ross Model of the Term Structure

Ren-Raw Chen and Louis Scott
The Review of Financial Studies
Vol. 5, No. 4 (1992), pp. 613-636
Stable URL: http://www.jstor.org/stable/2962143
Page Count: 24
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Pricing Interest Rate Options in a Two-Factor Cox--Ingersoll--Ross Model of the Term Structure
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Abstract

Solutions are presented for prices on interest rate options in a two-factor version of the Cox-Ingersoll-Ross model of the term structure. Specific solutions are developed for caps on floating interest rates and for European options on discount bonds, coupon bonds, coupon bond futures, and Euro-dollar futures. The solutions for the options are expressed as multivariate integrals, and we show how to reduce the calculations to univariate numerical integrations, which can be calculated very quickly. The two-factor model provides more flexibility in fitting observed term structures, and the fixed parameters of the model can be set to capture the variability of the term structure over time.

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