The pricing of options on debt securities

Abstract

W hile managers of equity portfolios have long been acquainted with traded options, managers of debt portfolios frequently find the emerging markets in debt options difficult to understand. Furthermore, while much of our knowledge of equity options can be transferred directly to the debt option markets, this is not true for one of the most difficult questions that must be addressed, namely, the fair value of an options contract. That question is the subject of this article. I shall show that equity option models are not directly applicable to debt options, but that we can use them in an altered form to value options on some debt securities. We should note at the outset, however, that an equity option model altered to take into account the characteristics of a debt security will not result in all cases in a good model for valuing debt options. These cases are discussed in more detail in the sections that follow.