Abstract
Publisher Summary This chapter reviews the various approaches to pricing interest rate options. The review has concentrated on a discrete time, discrete state space model and the continuous time analogues. The two problems are described in the chapter to which the interest rate option pricing theory is applied. The first problem is to value the entire zero coupon bond price curve, given the prices of only a few bonds (one, two or three) thatlie upon it. The second problem is to price contingent claims (options) on the zero coupon bond price curve. The chapter presents the identification of a theoretical difference between the model structures used to solve these two different problems. The distinction relates to the manner in which the spot-rate process' parameters are specified within the model. Zero curve arbitrage models require an exogenous specification of the spot-rate process. In option pricing models, however, the spot rate process is endogenously determined by an exogenous specification of the evolution of the entire zero coupon bond price curve. This distinction is important in the subsequent analysis.
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