August 5th, 2008, 2:53 pm
QuoteOriginally posted by: TraderJoeQuoteOriginally posted by: smalldoorboyHello, Since the payoff of buying bonds are quite similar to selling put options, can I use Black Scholes equation to price bonds? Are there any papers talking about this idea? Thank you very much.Can you be a little more specific? What type of bond - ZCB, coupon paying bond, fixed rate, floating rate, convertible? What type of put - European, American? What happens if the bond issuer defaults? Sorry if these questions sound trivial ...This model would best apply to bonds with a fixed payoff structure (i.e., not floating rate or convertibles) with the bond's payoff being the equivalent to premium earned by selling an OTM put. A default represents an exercise of the put option by the borrower to keep the lender's capital. One minus the recovery ratio represents how far ITM the long bond = short put option is. Because defaults can happen at anytime, but may be more prevalent on the maturity date (e.g., the borrower defaults when they find they can't roll the bond), the model would need to mix American and European elements.
Last edited by
Traden4Alpha on August 4th, 2008, 10:00 pm, edited 1 time in total.