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Pricing Stock and Bond Options when the Default-Free Rate is Stochastic

Published online by Cambridge University Press:  06 April 2009

Ramon Rabinovitch
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Abstract

We derive formulas for the valuation of call options on stocks and bonds when the defaultfree rate is stochastic. The formulas highlight the role of the correlation between the unanticipated returns on the underlying security and the changes in the short-term rate in determining the options value. Our numerical analysis indicates that option prices predicted by the proposed formula differ from those predicted by the Black and Scholes formula when this correlation is relatively large and the short-term rate's instantaneous variance is relatively large as well. Moreover, the proposed formula predicts higher (lower) stock option prices than those predicted by the Black and Scholes formula for correlation values that are lower (higher) than some positive critical value.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 24 , Issue 4 , December 1989 , pp. 447 - 457
Copyright
Copyright © School of Business Administration, University of Washington 1989

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