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

Author

Listed:
  • Lloyd P. Blenman

    (Department of Finance, University of North Carolina at Charlotte, 9201 University City Blvd, Charlotte, NC 28223, USA
    Deceased author.)

  • 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)

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.

Suggested Citation

  • Lloyd P. Blenman & Alberto Bueno-Guerrero & Steven P. Clark, 2022. "Pricing and Hedging Bond Power Exchange Options in a Stochastic String Term-Structure Model," Risks, MDPI, vol. 10(10), pages 1-17, September.
    • Handle: RePEc:gam:jrisks:v:10:y:2022:i:10:p:188-:d:927307
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    References listed on IDEAS

    as
    1. Santa-Clara, Pedro & Sornette, Didier, 2001. "The Dynamics of the Forward Interest Rate Curve with Stochastic String Shocks," The Review of Financial Studies, Society for Financial Studies, vol. 14(1), pages 149-185.
    2. Bueno-Guerrero, Alberto & Moreno, Manuel & Navas, Javier F., 2020. "Valuation of caps and swaptions under a stochastic string model," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 559(C).
    3. Wang, Xingchun, 2016. "Pricing power exchange options with correlated jump risk," Finance Research Letters, Elsevier, vol. 19(C), pages 90-97.
    4. Alberto Bueno-Guerrero & Manuel Moreno & Javier F. Navas, 2022. "Bond market completeness under stochastic strings with distribution-valued strategies," Quantitative Finance, Taylor & Francis Journals, vol. 22(2), pages 197-211, February.
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    Cited by:

    1. Boyi Li & Weixuan Xia, 2024. "Crypto Inverse-Power Options and Fractional Stochastic Volatility," Papers 2403.16006, arXiv.org, revised Sep 2024.

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