An Option Theory Based Yield Curve Model

Abstract

The Black-Scholes option theory provides a simple analytical model about the yields of corporate bonds. We extend the theory to model the yields of default free government bonds from a simple observation. From the purchasing power perspective, the values of corporate and government bonds follow similar patterns. The option theory based model of the term structure of interest rates explains major empirical patterns on the shapes and dynamics of yield curves. Compared with existing theories on yield curves, this theory provides a simple analytical theory without additional assumptions about risk, liquidity and preference. It greatly simplifies the understanding and teaching of yield curves.