Initial version: May 1992 Current version: June 1992

THE VALUATION OF DERIVATIVES: A SURVEY by E. Barone

The author wishes to thank Stefano Risa and Gianluca Salsecci for their helpful suggestions.

SUMMARY This note contains a survey of the financial literature on derivatives, starting from Bacheliers contribution to option pricing theory. After a brief analysis of forward, futures, options and repos (swaps have not been considered), we concentrated on options whose underlying assets are stocks or bonds. After distinguishing between standard and exotic options, we described the hypotheses made and the solutions obtained in pricing these financial instruments. The more complex topic of bond derivatives was then considered. We made a distinction between bond price and interest rate models, between continuous and discrete time models, between equilibrium and arbitrage models, between onefactor and multi-factor models. CONTENTS
1. 2. INTRODUCTION DERIVATIVES 1 2

2.1 2.2 2.3 2.4

3.

Forwards Futures Repos Options

OPTIONS ON STOCKS

2 3 4 4
5

3.1 3.2 3.3

4.

Stock prices Standard options European options American options Exotic options
OPTIONS ON BONDS

5 5 5 7 8
9

4.1 4.2 4.3

Bond price models Interest rate models Continuous-time models Discrete-time models Bond options

9 9 10 11 12
14 21

APPENDIX REFERENCES

1. INTRODUCTION According to their definition, derivatives are financial products that obtain their value from some other fundamental underlying assets. Forwards, futures, options, repos, swaps are considered derivatives, while spot contracts are not. Actually, some time it is the price of a derivative product that drives the prices of the underlying assets. For instance, futures and options markets often lead spot markets and spot contracts become the true derivative products: their value derives from futures and option prices.1 In extremis, we could also consider the credit market as a derivative market. In fact, by means of the put-call parity, using calls, puts and the underlying assets we can borrow and lend money at the risk free rate. But it is difficult stating that monetary markets derive from options markets ... . Derivatives and spot contracts influence each other, like interest rates in the bootstrap theory. Naturally, there are limits to the strength of the reciprocal influence. The Baron of Munchhausen tried to get to the moon by pulling the laces of his shoes, but he did not succeed. In the same way, it is unlikely that the market for Asian Rainbow stock options will ever influence the spot prices of the stock market. Derivatives are not quite new products. To quote Ingersoll: Financial contracting is as old as human history. Deeds for the sale of land have been discovered that date to before 2800 BC. The Code of Hammurabi (1800 BC) regulated, among other things, the terms of credit. Contingent contracting was also common. Under the Code crop failure due to storm or drought served to cancel that years interest on a land loan. The trading of the first option is probably equally ancient. Derivatives are not quite new products. To quote Ingersoll: Financial contracting is as old as human history. Deeds for the sale of land have been discovered that date to before 2800 BC. The Code of Hammurabi (1800 BC) regulated, among other things, the terms of credit. Contingent contracting was also common. Under the Code crop failure due to storm or drought served to cancel that years interest on a land loan. The trading of the first option is probably equally ancient. Less seriously, Sharpe quotes the case of an option bought in biblical times, with a premium paid in nature: In biblical times, Jacob bought an option to marry Rachel from her father Laban for seven years labor. But since provisions against fraud were not enforced by regulatory authorities, Laban was able to switch daughters at the time of delivery, and Jacob found himself married to Leah, the elder daughter. Undeterred, he agreed to work another seven years to obtain Rachel as well. The three did not live happily ever after, but that is another story. Finally, to quote Duffie: It is believed that futures trading may date back to India at about 2,000 B.C. ... . In this note we will try to trace the developments of the modern finance literature taking in consideration derivatives starting from Bacheliers contribution. At the very beginning of this century, in 1900, Louis Bachelier presented his doctoral thesis on Thorie de la spculation at the Ecole Normale Suprieure in Paris. His work contained fundamental insights in mathematics (he described brownian motions and martingales before the famous 1905 article of Einstein on thermodynamics) and in economics (the spot-forward relation and the basis of modern option pricing theory). Unfortunately, he did not receive the mention trs honorable from the University Committee and that influenced all his life. He remained a shadowy presence until 1960, or so, when his major work was revived in English translation. It is worth noting that the translation was cured by Boness, an other example of unrecognized genius. He came up with the same formula of Black and Scholes for valuing stock options, except for the fact that he used the expected rate of return on the stock, a, rather than the risk-free rate of interest, r. If Boness had carried his assumption that investors are indifferent to risk to its logical conclusion that a=r, he would have derived the Black-Scholes equation.2

1 2

According to Finucane (1991) option prices lead spot prices by at least 15 minutes. See Ingersoll (1987).

This note will give a special emphasis to options. We will try to follow a chronological order in describing the various contributions to the derivatives theory and, given an a priori scheme, we will try to locate the different articles as pieces of a puzzle. Derivatives can be classified according to their characteristics. The scheme that has been followed is represented in Table a1.3 We first distinguished the underlying assets according to their kind: stocks, bonds, currencies, commodities. For each kind of assets, we considered three classes of derivative contracts: forwards, futures, options, repos and swaps. Then for each class of contracts it is possible to explode the classification tree in order to take in account the peculiarities of the various contracts actually traded. A second classification regards the hypotheses formulated by the financial literature in order to determine theoretical values for derivatives (Table a2). They refer to: assets divisibility, transaction costs, taxes, regulatory rules (short sales), number of sources of uncertainty in the economy (factors) and their dynamics. Generally transaction costs and taxes are considered null and possible constraints on short selling are considered not binding. As far as the assets dynamics is concerned, the source of uncertainty may or may not be a traded asset: for instance, it would be a stock price if the derivative asset is a stock option, but it could also be an interest rate if one has to model interest-rate sensitive products. Generally it is assumed that the factor follows a diffusion process, some times a jump process, other times a mixed diffusion-jump process A third classification regards the type of solution to the valuation problems that one can find in the financial literature (Table a2). In some cases lower and upper bounds as well as exact formulas have been derived; in other cases analytical approximations and numerical methods to solve valuation problems have been proposed. Therefore these contributions can be divided in four categories: bounds, closed form formulas, approximate analytical solutions, numerical methods. 2. DERIVATIVES 2.1 Forwards The parity theory of forward exchange based on the law of one price was first formulated by Keynes (1923) and developed further by Einzig (1937), but as we noticed the spot-forward relationship was already shown by Bachelier. The spot exchange rate (S), the forward exhange rate (F) for delivery T, the T- maturity pure discount bonds denominated in the domestic (Pd) and foreign currency (Pf) must stand in a particular relation, in order to prevent arbitrage possibilities:

F (t , T ) =

SPf (t , T ) Pd (t , T )

(1)

This result, that defines the term structure of forward prices and that we can easily adjust in order to handle bid-ask spreads, should adapt the same expression in other markets. For example in the commodity market, as is clearly stated in Williams (1986), the spot and forward prices should stay in the same relation: we only need to replace the foreign currency interest rate with the interest rate for borrowing or lending that particular commodity. The relationship between the four markets is shown in Figure 1, which is known as the lakediagram.4 All four links are two-ways: one can trade lira now for dollars now, lira later for dollars later, lira now for lira later, dollars now for dollars later. Any of these 4 markets can be considered implicit, that is can be replicated by the other three: it is redundant.

3 4

Tables are in the Appendix. See for instance Sharpe (1985; pp. 548-551).

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Figure 1 Spot-forward parity

2.2 Futures Futures contracts require daily settlement of profits and losses, while with a forward contract, profits and losses are realized only at maturity or when the forward position is closed. The long (short) position can be unwinded by selling (buying) a forward contract with the same terms. The difference between futures and forward contracts lies in the fact that gains (losses) of a future contract can be invested (financed) at the short term interest rate, while gains or losses on forward contracts are not recognized until the contract matures or is liquidated: so the difference has to do with the timing of gains and losses. Originally, several papers confused forward and futures contracts by stating that a futures contract is identical to a forward contract rewritten at the end of each day. This mistake was independently noticed by Cox, Ingersoll and Ross (1981) and Jarrow and Oldfield (1981). The value of a forward contract is slightly different from the value of a futures, unless interest rates are zero. If futures and forward prices have increased on average since the positions were taken, the value of a long (short) futures position will be higher (lower) than the value of a long (short) forward position because of accumulated interest. The distinction between forward prices and futures prices is very much like the distinction between going long and rolling over shorts in the bond market. Each price is equal to the value of a claim which will pay a particular number of units of the underlying asset on the maturity date (s): this number is the total return which will be earned on an investment in a discount bond maturing at time s (forward price) or on a continual reinvestment in one-period bonds (futures price). If interest rates are non-stochastic the prices of the two contracts are equal (Black (1976)).5 The forward (futures) price of a portfolio is equal to a corresponding portfolio of forward (futures) prices: therefore any method for finding the forward (futures) price of a discount bond will also give the forward (futures) price for all coupon bonds. Cox, Ingersoll and Ross (1981) derived closed form formulas for forward and futures prices of contracts written on pure discount bonds and showed that the forward price G(t) is strictly greater than the futures price H(t), before maturity. They also showed that in a continuous time setting, where gains and losses on futures are settled continuously, futures prices are equal to the riskadjusted expected spot price at maturity. If taxes are collected continuously at constant rates, which are the same for all individuals, if capital gains are taxed as they accrue (with full loss offsets) and the receipts from futures price
5

Black assumes that the forward "price is always equal to the futures price" when the forward contract is initiated. See Morgan (1981).

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changes are taxed as capital gains then taxes will have no direct effect upon futures prices (Cox, Ingersoll, and Ross; 1981). Some additional institutional factors may have an effect on the futures prices. In some markets the seller of a futures contract has some degree of flexibility, given by a quality option, a quantity option, a timing option and a wild card option. The quality option allows the seller some discretion in the asset which can be delivered. In a continuous time setting, the futures price will then be equal to the risk-adjusted expected minimum spot price at maturity. The quantity option allows the seller some choice in the amount of the asset which is to be delivered. The futures price will not be affected because is quoted on a per unit basis. The timing option gives the seller some flexibility in the delivery date of the good: delivery can be made at any time during a designated period (s,s) beginning on the contracts maturity date. In this case, as a first approximation, the futures price can be determined as if the maturity date of the contract were s or s, depending on the rental rate of the asset being lower or higher than the interest rate. The investor who has an open short position in T-bond futures during the delivery month has the wild card option to deliver any combination of the deliverable issues at an invoice price that is fixed at the market closing (2 pm). The option expires at 8 pm. If the deliverable issues were to experience a significant price decline during the 2-8 pm. period, this option can have a considerable value. 2.3 Repos The spot-forward parity formula can be used in order to value repurchase agreements (repos), that can be considered derivatives too. In a repo contract one party agrees to buy spot and sell forward an asset to the other. In other terms, one party lends money to the other party and borrows the asset. Repos give operators a way to lend or borrow securities.6 The interest rate which is agreed upon in a repo is just the interest rate differential, D, that generally the forward buyer, but some time the forward seller, has to pay:

Pf (t , T ) F (t , T ) 1 = 1 S Pd (t , T )

(2)

The repo rate, in other words, is the interest rate implicit in the forward price, that interest which would preclude arbitrage via the strategy of buying (selling) the spot asset and selling (purchasing) it for later delivery in the forward market. 2.4 Options An option is a contract giving its owner, in exchange for a premium to be paid at issue (at maturity), the unconditioned (conditioned) right to undertake a spot (option, forward, futures, swap) contract in order to buy (sell) a unit (uncertain) quantity of the underlying traded (untraded) asset at a fixed (uncertain) exercise price (at any time before or) on a given (uncertain) date. A standard European call option is defined by the terms in italics. Some possible changes to the standard terms are indicated in parentheses. If the buyer of the option has the right to sell, instead of the right to buy, the contract is a put. If the option can be exercised at any time before or on a given date the option is said to be American. In the case of other changes to the standard terms, the option is said to be exotic (Table a3 and Table a4). As the covered interest rate parity links four markets (the monetary markets in domestic and foreign currencies, the spot and forward exchange rate markets), the put-call parity links other four markets (the call and put options markets, the forward market of the underlying asset and the domestic monetary market):7
6 7

See Williams (1986; chapter 2). The structure of some put/call parity theorems is outlined in Jarrow and Rudd (1983; table 6-4 p. 77).

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Figure 2 Put-call parity

c(t , T , K ) p (t , T , K ) = (F K )Pd (t , T )

(3)

For instance, investing in a pure discount bond (Pd) can be replicated by buying calls (c) and selling puts (p), with the same exercise price (K) and maturity (T), and selling forward the underlying asset at the forward price F (F > K). The reverse operation - selling calls, buying puts, buying forward applies if one wishes to borrow at the risk-free rate (Figure 2). 3. OPTIONS ON STOCKS 3.1 Stock prices The dynamics of stock prices has been modelled in various ways, in continuous and in discrete time, starting from Bacheliers arithmetic Brownian Motion. Diffusion, jump and mixed diffusion-jump models are available. A survey is in Table a5. La caratteristica principale dei processi diffusivi risiede nel fatto che essi rappresentano una sorta di passeggiata casuale (random walk)8 around a trend term and, in the short run, they offer no surprises. Put simply, according to a geometric brownian motion, the proportional change in stock value from t to t + dt is normally distributed with mean dt and variance 2dt. According to a jump process the proportional change in stock value is composed of a drift term dt and a term d which, with probability dt, will jump the proportional change to 1, possibly random itself, and with probability 1 dt will do nothing. 3.2 Standard options European options The earliest model of option pricing was developed by Louis Bachelier (1900). Assuming an absolute Brownian motion without drift (coherent with the zero-interest rate hypothesis) and with an instantaneous variance of r2, he derived the value of a European call option. The formula has two shortcomings: a) the use of absolute Brownian motion allows the stock price to become negative and the call option price to be greater than the stocks price; b) the zero-drift of the process assumes a null time value for money and risk neutrality. Nevertheless, the formula is quite good at predicting the prices of short-term calls.
8

"It is believed that the term was first used in an exchange of correspondence appearing in Nature in 1905. The problem considered in the correspondence was the optimal search procedure for finding a drunk who had been left in the middle of a field. The answer was to start exactly where the drunk had been placed. That point is an unbiased estimate of the drunk's future position since he will presumably stagger along in an unpredictable and random fashion" (Malkiel, 1987).

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Sprenkle (1964) went close to the Black-Scholes formula assuming a stationary lognormal distribution for stock returns and allowing for a positive drift in the stocks price, and even closer went Boness (1964), as we already saw. Samuelson (1965) recognized that the expected rate of return on the stock () and on the option () would generally be different due to their different risk characteristics. Samuelson and Merton (1969) recognized that the risk adjusted measures of and , and b would be the same. This approach anticipated the development of the risk-neutral or preference-free method of valuing options. . Assuming a geometric brownian motion for the stock price, constant interest rates, no dividends, Black and Scholes (1973) came out with their European stock option formula (Table a6). The breakthrough nature of the Black-Scholes analysis derives from their fundamental insight that a dynamic trading strategy in the underlying asset and a default-free bond can be used to hedge against the risk of a either a long or short position in the option (Merton, 1987). The most remarkable feature about the Black-Scholes model (1973) is that their formula does not depend on the stocks or the options expected rates of return or any measure of the markets risk aversion. Two operators who do not agree about the expected rate of return of the stock and of the option but agree about their volatilities will come out with the same option price. The Black-Scholes formula for European call options is based on a number of assumptions: a) b) c) d) e) f) g) there are no transaction costs; there are no taxes; there are no restrictions on short sales; the risk-free rate of interest is constant; ) the stock pays no dividend; v; the stock price follows a geometric brownian motion.

The Black and Scholes formula ignores interest changes and therefore ignore part of the risk. Merton (1973) relaxed the assumption sub d), assuming that the return variance of a bond with the same option maturity does not depend on the bond price level. In this model the variance turns out to be the average variance of the forward stock price over the options life. Merton (1973) relaxed also the assumption sub e) assuming a continuous dividend equal to a constant proportion of the stock price. Thorpe (1973) examined the assumption sub c). As far as the assumption sub b) is concerned, Ingersoll (1976) and Scholes (1976), assuming that dividends are taxed at a constant rate while capital gains are untaxed, adjusted the Merton proportional-dividend model. Merton (1976), Cox and Ross (1976a) and Cox, Ross and Rubinstein (1979; Table a7) considered the option pricing problem in a discrete-time setting, relaxing assumpion sub f). Leland (1985), using a continuous-time framework, allowed for transaction costs, sub a). Merton (1990) set up the problem in a discrete-time framework and derived the current option value when there are proportional transaction costs on the underlying asset. Boyle and Vorst (1992) extended the Cox, Ross and Rubinstein binomial option pricing model to cover the case of proportional transaction costs. Since the variances of stock prices do not appear to be constant, and since variance rates tend to rise as stock price fall, Black (1976) and Cox (1975) have proposed a constant elasticity of variance (CEV) generalization of the geometric brownian motion model. In the CEV model, stock price variances are allowed to change with the level of the stock price.9 Cox used discrete time difference equation approximations to estimate the CEV model. Two special cases of the CEV model have been analized: the square root model and the absolute model. An approximate analytical solution for a standard European call when the spot price follows a square root model has been given by Cox and Ross (1976; (36) p. 161). A simpler approximation, developed by Cox, has been reported in Beckers (1980). An analytical solution when the absolute price changes, dS, follow a constant variance diffusion has been given by Cox and Ross (1976; (39) p. 162).
Marsh and Rosenfeld (1984) examined the degree of bias in estimation of this model by maximum likelihood methods applied to "approximately equivalent" discrete time models. They found that there is very little estimation error for weekly observation intervals, but that the error increases as the interval lengthens to months and quarters
9

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Merton (1973), Cox and Ross (1976a), Jarrow and Rudd (1982) relaxed the assumption sub g) considering alternative stochastic processes like jump processes and mixed diffusion-jump processes. An analytical solution for a standard European call when the spot price follows a pure birth model has been given by Cox and Ross (1976; (29) p. 157). An important feature of option models based on jump processes is that the intensity parameter plays no role in the valuation since the hedge position depends only on the jump size. Merton (1976; (19) p. 135) has derived an approximate analytical solution for the case of mixed jump-diffusion model when the random variable which determines the jump amplitude is lognormal. Ceteris paribus, an option on a stock with a jump component in its return is more valuable than an option on a stock without a jump component. The incremental effort required to use Mertons model rather than the Black-Scholes model arises from the estimation of two or three additional parameters.10 Madan and Milne (1991; (6.8) p. 50) proposed a closed-form approximation to the European call option value when the stock price follows a martingale process termed the V.G. (variance gamma) by Madan and Seneta (1990). The Black and Scholes formula assumes that the spot price has a constant volatility, which is patently untrue. Hull and White (1987), Scott (1987) and Wiggins (1987) allowed volatility to be a stochastic process. If the variance parameter depends on time in a deterministic way then one has only to replace the variance in the Black and Scholes formula with the average variance over the options life. Kind (1988; (4.10) p. 30) derived a closed-form formula for a European call option on a risky asset whose price evolves according to an Ito process with an instantaneous variance given by a continuous-time GARCH process. European put options have been valued using the same methods or applying the put call parity. American options Merton (1973) proved that the value of an American call option is equal to the value of a European call option if the stocks does not pay dividend. The same result does not hold for a put option. Black (1975) suggested an approximation tecnique which gives a lower bound for the value of an American call option written on a stock with known dividends. Cox and Rubinstein (1985) labeled this approach a pseudo-American call Roll (1977) used the Geske (1979) compound option formula to develop an option model which values American calls written on a stock with known dividends. His approach has been discussed by Geske (1979, 1981) and Whaley (1981). Johnson (1983) gave an analytic approximation for the American put price. Geske and Johnson (1984) gave an other approximate analytical solution to the valuation of American puts by applying acceleration techniques common in numerical analysis but new to the finance literature. American options can also be valued using the numerical methods proposed by Brennan and Schwartz (1977) or within the binomial framework developed by Cox, Ross and Rubinstein (1979). The finite differences methods are based on finding a numerical solution to the differential equation that describes the assets price dynamics: the differential equation is converted into a set of difference equations and the difference equations are solved iteratively. The implicit and explicit method are available. The binomial approach to option valuation - also known as the lattice approach - was first suggested by Sharpe in 1978, as recognized in Cox, Ross and Rubinstein (1979). These authors assumed that the stock price follows a binomial process moving from its initial value, S, in only two possible directions, Su or Sd. They also assumed that the process recombines, imposing a path-independence constraint: if the price first moves up and then down, then it comes back where it started from. As showed in Figure 3, this process yields a tree (or lattice) of stock prices.

10

A study that details the estimation problems is by Beckers (1981).

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Figure 3 Binomial tree for the stock price

Generally the tree first works forward: from the current underlying price, a range of possible prices (or interest rates) at the expiration date is obtained, as well as the risk-adjusted probabilities for each outcome. In a second stage, the prices of the derivative (and the composition of the replication portfolios) are computed backwards, starting from the boundary conditions and using the riskadjusted probabilities. This method approximates both the stochastic process and the exerciseopportunity set, the latter by restricting exercise to a discrete set of dates. Simple binomial processes as diffusion approximations can be found in Nelson and Ramaswamy (1990). An other possibility is to use Monte Carlo simulations (Boyle 1977). The distribution of asset values at any future date is determined by the process describing the asset prices dynamics and can be simulated on a computer. Each time a simulation is done, a terminal asset value is generated. Then, if this simulation process is done several times - or rather several thousand times - the result is a distribution of terminal asset values from which one can directly extract the expected asset value at maturity. Parkinson (1977) proposed numerical integration, replacing the probability density with discrete probabilities. Jarrow and Rudd (1982) proposed to approximate the true stock distribution with the lognormal distribution using Edgeworth Series. Finally, if a continuous record of observations is available, an assumption not irrealistic whenever the modern information technology is used in collecting the data, a general MaximumLikelihood approach can be used in order to estimate the stochastic differential equations (Cesari, 1989). Samuelson (1965) conjectured and Merton (1973) proved that the value of American options and the optimal exercise rule can be determined simultaneously by imposing the high contact condition, that is the tangency condition at the optimal exercise time of the slopes of the pricing function and of the payoff function. Macmillan (1986) originally suggested valuing options using a quadratic approximation approach. The approach was implemented by Barone-Adesi and Whaley (1987). Kim (1989), Carr, Jarrow and Myeni (1989) and Jacka (1989) have separately derived equivalent formulas for American put options in terms of the optimal exercise boundary. Barone-Adesi and Elliott (1991) found an algebraic equation for the optimal exercise boundary, enabling them to obtain an approximate solution for valuing American options. Jamshidian (1990; (4) p. 8) represented an American option as a portfolio of a European option and an artificial cash flow representing the delayed exercise compensation. The early exercise premium is the the discounted expected value of this continuous cash flow. Combined with the results of Barone-Adesi and Elliott (1989) for the optimal exercise boundary, this interpretation provides a means for the efficient computation of American options on equities with continuous dividend yield. . 3.3 Exotic options A scheme containing the various kinds of exotic options created by the operators is in Table a4. The academic literature on exotic options starts with the article by Merton (1973; pp. 175-176) on down and out options.

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Goldman, Sosin and Gatto (1979) analyzed lookback options in the article Path-Dependent Options: Buy at the Low, Sell at the High. The results of their paper are generalized by Garman (1989) to include a non-zero own interest rate on the underlying asset. Goldman, Sosin and Gatto (1979) analyzed lookback options in the article Path-Dependent Options: Buy at the Low, Sell at the High. The results of their paper are generalized by Garman (1989) to include a non-zero own interest rate on the underlying asset). Fisher (1978) and Margrabe (1978) priced an option for the exchange of two risky assets, while Stulz (1982) was the first to analyze the pricing of European options on the maximum or the minimum of two risky assets. Johnson (1987) generalized the earlier results with an elegant solution to the problem of pricing options on the maximum or the minimum of n assets based on similar assumptions to those underlying the Black and Scholes formula (multivariate geometric Brownian motion, constant interest rates, perfect markets, etc.). Barone and Bucci (1991) generalized Johnsons formula in order to take into account non-zero own interest rates for the underlying assets. Numerical tecniques for valuing American options written on several assets are developed by Boyle, Evnine and Gibbs (1989) and by Boyle and Tse (1990). Pay-later options on spot and forward contracts have been analyzed, respectively, by Turnbull (1992) and Barone and Cuoco (1989). Longstaff (1989; (7),(12) pp. 6-10) derived closed-form expressions for calls and puts that are extendible by either the option holder or the option writer. An extensive survey of exotic options is in Rubinstein (1991). 4. OPTIONS ON BONDS In order to evaluate options on bonds, one can model bond prices or a simple transformation of bond prices, ie. interest rates. This last approach is more common: it is generally considered simpler to start from one or more benchmark interest rate processes and thence infer a process for bond prices rather than to immediately postulate a process for bond prices. Taxes are a difficult problem in the valuation of interest-related contracts. Differential taxation of capital gains and interest income is likely to induce tax clientele effects. As a result, it is unlikely that all bonds are priced using one market-wide marginal tax rate. We cant price coupon bonds as a combination of zero-coupon bonds unless we know, for each bond, the marginal tax bracket of the marginal bondholder. And if we cant price bonds, we have more of a problem in valuing and replicating derivative contracts. See Katz and Prisman (1991). 4.1 Bond price models One cannot apply to bond prices the same dynamics of stock prices. Bond prices converge to unity at maturity and this implies that, approaching maturity, volatilty decreases. Ball and Torous assumed a bridged lognormal process for bond prices, that is a model where the bond value at one particular date (maturity) is known with certainty. Adding an assumption of constant interest rates they came up with a closed-form formula. A weakness of the bridged process is that its variance is still assumed to be constant; convergence is achieved by negative autocorrelation among returns rather than by a price-dependent drift and variance. Another simple approach is to postulate that the (price-dependent) variance (or the standard deviation) of the discount bonds price process decreases proportionally with (Hicksian) duration. Schaefer and Schwartz (1987) used this approach). 4.2 Interest rate models Interest rate modelling has followed two different methods: equilibrium and arbitrage methods. Both need to specify: (a) the variables on which the bond price depends, (b) the stochastic properties of the underlying variables (their dynamics), (c) the market equilibrium condition. The first approach derives the equilibrium condition after a detailed description of the underlying economy. The second

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approach assumes the market equilibrium condition under the constraint of no arbitrage opportunities.11 The first approach, pioneered by Cox, Ingersoll and Ross, has been followed by Longstaff (1990) and Longstaff-Schwartz (1991). Arbitrage methods have been developed in continuous and in discrete time. Continuous-time models A scheme representing one-factor continuous-time interest rate models is in Table a8. A simple case of the Gaussian model originally appeared in Merton (1973) and a meanreverting generalization was studied in Vasicek (1977). Other examples of arbitrage models are provided by the work of Brennan and Schwartz, Courtadon, Dothan, Garman, Richard, Jamshidian. Merton (1973; note 43, p. 163), assuming an arithmetic brownian motion for r and using the pure local expectation hypothesis, derived the first closed-form formula for a pure discount bond. Similarly Vasicek (1977), assuming an Ornstein-Uhlenbeck process for the absolute changes of the instantaneous interest rate, dr.. As Jamshidian (1987) pointed out, The disadvantage of the Gaussian process is that interest rates, being normally distributed, may become negative. Similarly, discount bond prices are lognormally distributed and hence may exceed unity. However, by choosing a positive speed of reversion to mean j, the variance of will not grow linearly with time; rather, it will be bounded. Hence the probability of becoming negative is mitigated. The advantage of the Gaussian process is that it is quite tractable. Dothan (1978; (15) p. 65) assumed a geometric brownian motion without drift for the instantaneous interest rate and obtained a cumbersome analytical solution to the problem of valuing pure discount bonds. Brennan and Schwartz (1980b) and Courtadon (1982) tried to encompass the problems of Vasicek and Dothan approaches superimposing to Dothans model the deterministic mean-reversion component of Vasicek. Negative interest rates are precluded in their model but no closed-form formula is available. Courtadon suggested to solve the valuation problem using a finite differences method. Jamshidian (1987) extended the Vasicek model by allowing the drift of the instantaneous rate to be time varying in such a way that one can incorporate into the model an initially prescribed volatility curve. Longstaff (1989), studying a double square root model, showed that bond prices and the instantaneous rate are not always inversely related and that bond risk does not need to be strictly increasing in maturity. An empirical comparison of different one-factor models is in Marsh and Rosenfeld (1983), Fischer and Zechner (1984), Chan, Karolyi, Longstaff and Sanders (1990). There are some problems with all bond pricing models that start from an interest rate processjjj: - in the two-stage approach one has first to estimate the parameters of the interest rate process using time-series data and then infer the risk parameter k from the bond prices. If we estimate a unique k we never perfectly explain the observed bond prices. We could perfectly explain the observed bond prices using different k for each bond, but this is not consistent with the model; - in the one-stage approach one can jointly estimate all parameters running non-linear crosssectional regressions of bond data. In this case there is no guarantee that the instantaneous interest rates are near the values estimated from direct time-series analysis of short-term rates. Likewise, it is possible that the assumedly constant parameters turn out to vary over time. A specific problem with all one-factor models is that the long term asymptotic rate is constant. To some extent, this conflicts with empirical evidence: long-term yields do exhibit substantially lower variability then overnight or one-month rate, but they manifestly are not constant. It is not too clear, though, to what extent this is really a problem. ... When a mathematical model says infinity it means
11 However, the arbitrary choice of the functional form for factor risk premiums in the market equilibrium condition can lead to internal inconsistencies. See Cox, Ingersoll and Ross (1985; pp. 397-398).

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infinity, not 10 or even 30 years. Moreover, ... even within this class of models, consol yields can still vary over time. A second general criticism is that all one-factor models predict a perfect positive correlation of instantaneous returns. This is, in principle, a testable implication. But empirical tests of this implication can never be impeccable .... For equilibrium pricing of bonds, the coefficients of the interest rate process are normally assumed time independent. But for the pricing of contingent claims, e.g., options on coupon bonds, it is important that the interest rate process be specified so as to incorporate the relevant information in the market yield curve, specially the price of the underlying bond. This requires sufficient degrees of freedom in the choice of coefficients for the interest rate process. For example one may choose the drift term time dependent in such a way as to match a prescribed discount function.12 Cox, Ingersoll and Ross (1985; (29) p. 395) gave an integral equation which may be solved numerically. Ahn and Thompson (1988) obtained an approximate analytical solution to the valuation of pure discount bonds under the hypothesis that the instantaneous interest rate follows a mixed jumpdiffusion process. They showed that bond prices are strictly higher under jump risks than otherwise. In the Brennan-Schwartz (1979) two factor model the state variables chosen are the instantaneous interest rate and the consol yield. In a subsequent article (1980) the authors, testing its predictive ability found evidence of a third unobserved explanatory factor. Then, applying the model to U.S. Government bonds data (1982a) found evidence of a strong relationship between pricing errors and bond returns even outside the sample period over which the pricing model was estimated.13 The two-factor model of Brennan and Schwartz was tested by Babbel (1988) for its out-ofsample predictive ability, that turned out to be modest. In the Schaefer and Schwartz model (1984) the two factors are given by the consol rate and the spread between the consol rate and the instantaneous rate. The authors propose an approximate analytical solution to the bond valuation problem. In the Cox, Ingersoll and Ross (1985; (54) and (56) p. 403) two-factor models the state variables chosen are the instantaneous interest rate and the price level. The last one is allowed to follow one of two different processes. Longstaff and Schwartz (1991) developed a general equilibrium model of the term structure of interest rates using the Cox, Ingersoll, and Ross framework and two factors (the short rate and the instantaneous variance of changes in the short-term interest rate). They derived closed-form expressions for discount bond prices and for discount bond option prices. An analogous approach has been taken by Fong and Vasicek (1991) who priced fixed-income instruments, under the equilibrium condition of no-arbitrage, with a two-factor model in which the state variables are the short rate and its instantaneous variance. Cesari (1992; chapter I.5) derived closed-form formulas for 3-factors Feller and OrnsteinUhlenbeck models. Jamshidian (1989b) studied the multifactor general Gaussian model and presented a numerical algorithm for the valuation of contingent claims in the presence of one or several interest rate factors. Heston (1989) developed multiple factor generalizations of the Cox, Ingersoll and Ross univariate model. The closed-form formula of Vasicek has been generalized by Beaglehole and Tenney (1991; p. 73) to the n-factors case. Beaglehole and Tenney (1991; (16) p. 78) also derived a valuation formula in the case of the multivariate quadratic model which admits a time-dependent drift. Discrete-time models While some models are defined in continuous time others have been developed in discrete time.14 The early efforts of this type echoed the continuous-time models, and can also be viewed as a numerical procedure to solve continuous-time equations.

12 13

See Sercu (1991). See also Brennan and Schwartz (1982b). 14 Often their continuous time limit is available.

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Rendleman and Bartter (1980) considered a geometric brownian motion for r in discrete time. They rolled out a binomial tree of future one period (continuously compounded) interest rates starting from the observed one. Then they showed how to value bonds working backwards along the binomial tree from the terminal condition. The Rendleman and Bartter approach shares with the continuous-time models the problem that existing bonds can be found to be mispriced. Ho and Lee (1986) tried to avoid this by constraining the theoretical bond prices to be equal to the actual ones. The result has been achieved by letting the drift term of the process driving r to be time-dependent. Jamshidian (1987; p. 12) pointed out that the continuous time limit of Ho and Lee model corresponds to the following Gaussian process for the interest rate, with a vanishing speed of reversion to mean :

dr = [ (t ) ( + )r ]dt + dz. Four critics have been formulated to the Ho and Lee model: it can produce negative interest rates; all spot and forward interest rates have the same volatility; the shape of the term structure remains unchanged in the future; bond returns are perfectly correlated.

(4)

Dybvig (1989) showed how to derive a whole class of term structure models based on existing bond and bond option pricing models and the term structure at a point of time. Kishimoto (1989) and Morgan and Neave (1989) proposed a model similar to Ho and Lee, offering alternative ways of modelling the term structure without assuming constant conditional variance of bond rates. Moreover, their models do not imply that spot rates can become negative over many periods. Bliss and Ronn (1989) offered a trinomial version of Ho and Lee. Morgan and Neave (1989), using a binomial process of spot rate evolution, generated explicit expressions for forward and futures prices written against Treasury bills. Black, Derman and Toy (1990) expanded on the Ho and Lee model by specifying a timevarying structure for volatility. The Ho and Lee model has been generalized by Heath, Jarrow and Morton (1990). They allowed the up and down factors and their probabilities to change over time, and allowed for two sources of risk rather than just one. Starting from the current forward rate function, one first rolls out the entire tree of forward rate term structures (including the one-period interest rate). These term structures then imply a term structure of bond prices for each node. Now the tree is, in a sense, quadrinomial rather than binomial and more efficient computational procedures are needed. Since the number of paths increases exponentially with the total number of time periods, one is generally severely limited in the total number of periods that can be taken.15
4.3 Bond options

One problem with options on bonds is that, unless the bond is perpetual, its maturity keeps changing. As the bond approaches maturity, volatility tends toward zero. Many bond option models rest on relatively simple processes for interest rates, that are likely to miss part of the action like jumps in interest rates or in their volatility. Stapleton and Subrahmaniyam (1987) valued American options on bond portfolios approximating the mean-reverting stochastic process with a two-state process and then using dynamic programming to evaluate the optimal exercise strategy and the value of the option. Jamshidian (1987; (22) p. 14) priced options on pure discount bonds using Vasiceks model. In the same paper (1987; p. 11) he priced a European call option on the future contract on a discount bond, using the Cox, Ingersoll, and Ross one-factor model.

15

The model is commercialized through BARRA's Derivatives Analysis System. Valuation has been significantly speeded up "with a five-year cap priced in 3.9 seconds, a five-year European swaption in less than 9 seconds and an American swaption in 55 seconds" (Risk, vol.5, no.5, May 1992).

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Jamshidian (1987; p. 11-12) ha dimostrato che, poich i prezzi dei discount bond sono funzioni decrescenti di r, le opzioni su coupon bond e su futures scritti su coupon bond equivalgono a portafogli di opzioni con appropriati prezzi di esercizio. Longstaff (1990) ha ricavato semplici espressioni chiuse per le opzioni europee su coupon bond nellambito del modello di equilibrio generale sviluppato da Cox, Ingersoll e Ross. Jamshidian (1989) ha derivato una formula chiusa per la valutazione di opzioni multiple su discount bond (Unopzione multipla offre al suo detentore il diritto di esercitarla ad una ed una sola scadenza nellambito di diverse possibili. Lopzione americana costituisce un caso limite di opzione multipla) e ha dimostrato come unopzione multipla su di un coupon bond equivalga a un portafoglio di opzioni multiple su discount bond. Ho (1985) derived closed form solutions to options on discount bonds and futures options on discount bonds, in the framework given by the Ho and Lee model. Jamshidian (1990; (23) p. 15 and (27) p. 16) obtained explicit formulas for American bond options in the Vasicek Gaussian model and the Cox, Ingersoll and Ross square-root model. Beaglehole and Tenney (1991; (9) p. 74) generalized the European call option formula of Jamshidian (1989) for the n-factors Gaussian process. The formula is a function of only two random variables - the time to expiration of the option and the forward rate, or in other terms depends only on the forward rate and the repo rate. Besides, Beaglehole and Tenney (1991; (17) p. 78) derived a valuation formula for European call options, in integral form, also in the case of the multivariate quadratic model. The integral may be valued numerically. In the same article (1991; p. 90), they also show a closed-form (integral) solution for European call options using the second version of the twofactor Cox, Ingersoll, and Ross model. Jamshidian (1991) presented an algorithm for building interest rate models consistent with a given initial yield and volatility curve. One fits the yield curve by forward induction and subsequently evaluates contingent claims by backward induction. Amin (1991) developed a class of discrete, multivariate models as continuous time approximations for pricing American options. Taking the term structure as given, using the work of Heath, Jarrow and Morton (1992) and imposing the simplifying assumption that the variance is non-random, Musiela, Turnbull and Wakeman (1991) derived closed form solutions for European Treasury bill and bond futures options. Beaglehole and Tenney (1991; (39) and (40) p.82) derived a closed-form solution for European call options on interest rates (Caps) using the Cox, Ingersoll, and Ross square root and the Vasicek model. The quality option implicit in futures contracts has been studied by several authors. The papers of Garbade and Silber (1983), Gay and Manaster (1984, 1986), Hemler (1990), Kilcollin (1982) and Livingston (1984) address the problem of the impact of the quality option on futures prices. Kane and Marcus (1986) address the so-called wild card option feature of Treasury bond futures contracts. Broadie and Sundaresan (1991) simultaneously analyzed the quality and timing aspects of the Treasury bond futures contract on the basis of the univariate Cox, Ingersoll, and Ross model and of the discrete time, discrete state space trinomial lattice suggested by Hull and White (1990b). Quality options substantially reduce the futures price below its level in their absence. Boyle (1989) obtained numerical results by imposing very strong simmetry conditions on the problem and Boyle and Tse (1990) addressed the same problem using the Clark algorithm. Barone-Adesi and Elliott (1989), assuming lognormality for bond prices, extended Johnsons formula (1987). The assumption of lognormality of bond prices ignores the fact that the value of the bonds is known at maturity and limits potential extensions of the model to futures contracts on shorter term instruments.

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APPENDIX

TABLE a1 Derivatives

TABLE a2 Valuation problems

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TABLE a3 Standard options

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TABLE a4 Exotic options

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TABLE a5 Stocks: The dynamics of spot prices

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TABLE a6 European standard options on spot contracts: Black-Scholes

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TABLE a7 European standard options on spot contracts: Cox-Ross-Rubinstein

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TABLE a8 Bonds: One-factor term structure models in continuous-time

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