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The Direct Approach to Debt Option Pricing

(by Sven Rady, with Klaus Sandmann)


Review of Futures Markets 13(2), 1994

The paper was circulated as Discussion Paper No. B-212 of Sonderforschungsbereich 303, University of Bonn, Germany.

We review the continuous-time literature on the so-called direct approach to bond option pricing. Going back to Ball and Torous (1983), this approach models bond price processes directly (i.e. without reference to interest rates or state variable processes) and applies methods that Black and Scholes (1973) and Merton (1973) had originally developed for stock options. We describe the principal modeling problems of the direct approach and compare in detail the solutions proposed in the literature.

Keywords: Arbitrage, Debt Options, Option Pricing
JEL Classification: G13

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