Pricing options on short-term interest rates using discrete arbitrage-free models

Abstract

On June 23 1989, the Chicago Board of Options Exchange introduced a new option on short-term interest rate. These options were unique in that, unlike other interest rate dependent options, there were no assets like bonds underlying them. So, when these options are exercized, settlement delivery is in cash. These options opened new avenues for investors interested in hedging and speculating on interest rate movements. In the present study these short-term interest rate option markets are analysed utilizing recent developments on discrete interest rate stochastic processes. Of the various models developed to price interest contingent claims, Ho and Lee (1986) is especially important since these researchers use the entire term structure to derive relatively simple arbitrage based models. In this study these newly introduced options on interest rates are priced and empirically tested using the modified version of a Ho and Lee term structure model.