The Direct Approach to Debt Option Pricing

by Sven Rady of the London School of Economics, and
Klaus Sandmann of the Rheinische Friedrich-Wilhelms-Universität Bonn

March 22, 1995

Abstract: We review the continuous-time literature on the so-called direct approach to bond option pricing. Going back to Ball and Torous (1983)[REF], 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 modelling problems of the direct approach and compare in detail the solutions proposed in the literature.

JEL Classification: G13.

Keywords: Arbitrage, Debt Options, Option Pricing.

Published in: Review of Futures Markets, Vol.13, No. 2, (March 1994), pp. 461-515.

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