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J o u rn a l
o f
F in a n c ia l
E c o n o m ic s
2 6
(1 9 9 0 )
9 7 -1 2 1 .
N o rth -H o lla n d
T he
v a lu a tio n
o f o p tio n s
o n y ie ld s
F ra n c is
A . Longstaff
*
T h e
O hio
S ta te
U n icers it y , C o lu m b u s ,
O H
4 3 2 1 0 -1 3 0 9 .
U SA
R e c e iv e d
S e p te m b e r
1 9 8 9 ,
fin a l
v e rs io n
re c e iv e d
M ay
1 9 9 0
M any
c o n tin g e n t
claim s
in c o rp o ra te
o p tio n s
o n
y ie ld
le v e ls .
I d e riv e
c lo se d -fo rm
e x p re s s io n s
fo r
E u ro p e a n
y ie ld -o p tio n
p ric e s
u s in g
a general
e q u ilib riu m
m odel
i n
w h ic h
th e
u n d e rly in g
y ie ld
i s
th e
re le v a n t
s ta te
v a ria b le .
T he
p ro p e rtie s
o f
th e s e
o p tio n s
d iffe r
m a rk e d ly
fro m
th o s e
o f
c o n v e n tio n a l
o p tio n s
o n
tra d e d
a s s e ts .
F o r
e x a m p le ,
y ie ld -c a ll
v a lu e s
c a n
b e
le s s
th a n
th e ir
in trin s ic
v a lu e
a n d
c a n
b e
d e c re a s in g
fu n c tio n s
o f
th e
u n d e rly in g
y ie ld .
T h e s e
fe a tu re s
h a v e
im p o rta n t
h e d g in g
im p lic a tio n s .
Ie x a m in e
th e
e m p iric a l
im p lic a tio n s
o f
th e
m odel
u s in g
p ric e
d a ta
fo r
th e
13-w eek
T -b ill
o p tio n s
tra d e d
o n
th e
C h ic a g o
B oard
O p tio n s
E x c h a n g e .
1 .
In tr o d u c tio n
U n fa v o ra b le
s h if ts
i n
th e
te r m
stru c tu re
a re
o n e
o f
th e
m ost
b a s ic
r is k s
fa c in g
fin a n c ia l-m a rk e t
p a rtic ip a n ts .
V o latile
in te re s t
ra te s
d u rin g
th e
p a s t
d e c a d e
h a v e
m a g n ifie d
th is
r is k
a n d
h a v e
le d
t o
a dram atic
in c re a s e
i n
th e
num ber
a n d
ty p e s
o f c o n tin g e n t
claim s
th a t
in c o rp o ra te
o p tio n s
o n
th e
le v e l
of yields. These
o p tio n s
d iffe r
fro m
o p tio n s
o n
b o n d s
in that
th e
u n d e rly in g
s ta te
v a ria b le
is a
y ie ld .
F o r
e x a m p le ,
in te r e s t- r a te
c a p s ,
flo o rs,
lo c k s ,
a n d
flo o r-c e ilin g
agreem ents
a re
sim p le
p o rtfo lio s
o f o p tio n s
o n
y ie ld s .
F lo a tin g -
r a te
n o te s
and bonds
o fte n
in c lu d e
lim its on the
s iz e o f th e
r a te
a d ju s tm e n t,
a
fe a tu re
th a t
c a n b e m o d e le d
a s a y ie ld
o p tio n .
A
g ro w in g
num ber
o f fin a n c ia l
in s titu tio n s
is s u e
c e rtific a te s
of deposit
th a t
g u a ra n te e
a
m inim um
renew al
y ie ld
if the
c e rtific a te
is rolled
o v e r
a t m a tu rity .
T h is
renew al
g u a ra n te e
i s
sim p ly
a put
o p tio n
o n
th e
fu tu re
y ie ld .
M any
o th e r
c o n tin g e n t
claim s, such
* I
a m
g ra te fu l
fo r
th e
c o m m e n ts
o f
W arren
B a ile y ,
F is c h e r
B la c k ,
S te v e
B user.
P e te r
C arr,
K C .
C han.
B ruce
G ru n d y ,
M ic h a e l
H em ler,
C o le m a n
K e n d a ll,
D a v id
M ayers,
H u s to n
M c C u l-
lo c h ,
T o n y
S a n d e rs ,
C hester
S p a tt.
R ene
S t& ,
a n d
F in a n c e
w orkshop
p a rtic ip a n ts
a t
C a rn e g ie
M ello n
U n iv e rs ity ,
T he
O h io
S ta te
U n iv e rs ity ,
a n d
th e
U n iv ersity
o f
M in n e s o ta .
I
a ls o
w ish
t o
th a n k
W ai-M in g
F o n g
fo r
re s e a rc h
a s s is ta n c e .
T he
c o m m e n ts
a n d
s u g g e s tio n s
o f
th e
e d ito r,
C liffo rd
S m ith ,
J r .,
a n d
E d u a rd o
S chw artz,
th e
re fe re e ,
w ere
p a rtic u la rly
h e lp fu l.
A ll
e r r o r s
a re
m y
re s p o n s ib ility .
0 3 0 4 ~ jo 5 X /9 0 /5 0 3 .5 0
0
1 9 9 0 -E ls e v ie r
S c ie n c e
P u b lis h e rs
B .V .
(N o rth -H o lla n d )
9 8
F .A . L o n g s ta ff
V a lu in g o p t io n s
o n
& 4 is
a s a d ju s ta b le -ra te
m ortgages,
o p tio n s
o n
in te r e s t- r a te
s w a p s , o p tio n s
o n
th e
a c tiv e ly
tra d e d
E u ro d o lla r
fu tu re s
c o n tra c t,
a n d
e x te n d ib le
c o rp o ra te
b o n d s ,
in c o rp o ra te
y ie ld
o p tio n s .
C o n s e rv a tiv e
e s tim a te s
o f th e
to ta l
p rin c ip a l
v a lu e
o f c o n tin g e n t
c la im s c o v e re d
by som e
fo rm
o f a y ie ld
o p tio n
are w ell in excess
o f $ 5 0 0 b illio n .
In this
p a p e r,
I d e riv e
c lo se d -fo rm
e x p re s s io n s
fo r th e
v a lu e s
of European
c a lls a n d
p u ts
o n y ie ld s ,
u s in g
a n
e x te n d e d
v e rs io n
o f th e
C o x , In g e rs o ll,
a n d
R o s s (1 9 8 5 b ) g e n e ra l-e q u ilib riu m
term -stru ctu re
fram ew ork.
In this version,
I
u s e th e
T -m atu rity
y ie ld
a s th e
re le v a n t
s ta te
v a ria b le
in pricing
a n o p tio n
o n
th e
T -m atu rity
y ie ld .
T h is
a p p ro a c h
a llo w s th e
m odel
to c a p tu re
th e
le v e l o f
th e
y ie ld
c u rv e
a t th e
most relevant
m atu rities
fo r p ric in g
y ie ld
o p tio n s .
I also
d e riv e
c lo se d -fo rm
e x p re s s io n s
fo r th e v a lu e s
o f o p tio n s
on average
y ie ld s
a n d
y ie ld
s p re a d s
by showing
th a t
th e s e
c la im s c a n
be represented
a s p o rtfo lio s
o f
y ie ld
c a lls
a n d
p u ts ,
T he
p ro p e rtie s
o f
y ie ld -o p tio n
p ric e s
a re
fu n d a m e n ta lly
d iffe re n t
fro m
th o s e
o f c o n v e n tio n a l
o p tio n
p ric e s .
T h is
is because
y ie ld s
-
a lth o u g h
sim p le
n o n lin e a r
fu n c tio n s
of bond
p ric e s
-
a re
n o t th e m s e lv e s
th e
p ric e s
of traded
a s s e ts .
C o n s e q u e n tly ,
th e y
n e e d
n o t fo llo w
a m a rtin g a le
u n d e r
th e
e q u iv a le n t
m a rtin g a le
m easure
d e s c rib e d
b y
H arriso n
a n d
K reps
(1 9 7 9 )
a n d
H arriso n
a n d
P lis k a
(1 9 8 1 ).
O ne
im p lic a tio n
is that
th e
p ric e
o f a c a ll o n
a yield
c a n
e x c e e d
th e
y ie ld \u2019s
c u rre n t
num erical
v a lu e .
S im ilarly ,
th e
p ric e
o f a y ie ld
c a ll
c a n
b e
le s s th a n
its intrinsic
v a lu e .
I show
th a t
th e
v a lu e
o f
a y ie ld
c a ll n e e d
n o t b e a m o n o to n e
in c re a s in g
fu n c tio n
o f th e
u n d e rly in g
y ie ld . A n
in c re a s e
i n
th e
y ie ld
in c re a s e s
n o t
o n ly
th e
e x p e c te d
p a y o ff
fo r
th e
c a ll,
b u t
a ls o
th e
d is c o u n t
r a te
fo r
th e -p a y o ff,
w h ic h
e v e n tu a lly
d o m in a te s .
T h is
fe a tu re
h a s
im p o rta n t
im p lic a tio n s
fo r
h e d g in g
in te r e s t- r a te
r is k
w ith
y ie ld
o p tio n s .
F u rth e rm o re ,
I show
th a t
y ie ld -c a ll
p ric e s
c a n
a c tu a lly
b e
d e c re a s in g
fu n c -
tio n s
o f
th e
tim e
u n til
e x p ira tio n
a n d
th e
v o la tility
o f
th e
u n d e rly in g
y ie ld .
C o rre s p o n d in g
r e s u lts
h o ld
fo r y ie ld
p u ts .
T o
e x a m in e
th e
e m p iric a l
im p lic a tio n s
o f
th e s e
r e s u lts ,
I
fo c u s
o n
th e
v a lu a tio n
o f
th e
re c e n tly
in tro d u c e d
E u ro p e a n
o p tio n s
o n
th e
13-w eek
T re a su ry -b ill
y ie ld
tra d e d
o n
th e
C h ic a g o
B oard
O p tio n s
E x c h a n g e
(C B O E J.
T he
sam ple
c o v e rs
th e
first six m onths
o f tra d in g ,
b u t e x c lu d e s
d a y s o n w h ic h
th e
o p tio n s
a re
n o t a c tiv e ly
tra d e d .
O ver
4 5 0 c a ll a n d
p u t p ric e s
a re
in c lu d e d .
In te re s tin g ly ,
m ost
o f th e
p ric e s
o f in -th e -m o n e y
calls are
b e lo w
th e ir
in trin -
s ic
v a lu e s .
T h is
i s
c o n s is te n t
w ith
th e
p ric in g
m odel
o f
th is
p a p e r,
b u t
in c o m p a tib le
w ith
a lte rn a tiv e
p ric in g
m o d e ls
b a s e d
o n
th e
B la c k -S c h o le s
(1973) or Black
(1 9 7 6 ) fo rm u la s.
I n
a d d itio n ,
I show
th a t
d e v ia tio n s
fro m
th e
tra d itio n a l
p u t-c a ll
p a rity
re la tio n
a re
p o s itiv e ly
re la te d
t o
th e
m atu rity
o f
th e
o p tio n s ,
a s im p lie d
b y th e
y ie ld -o p tio n
m o d e l.
L ik e
R u b in s te in
(1 9 8 5 ), I
te s t
fo r
m odel
b ia s e s
b y
in fe rrin g
th e
v o la tility
param eter
fro m
o b s e rv e d
o p tio n
p ric e s
a n d
th e n
e x a m in in g
w h e th e r
th e
im p lied
v o la tility
e s tim a te s
a re
s y s te m a tic a lly
re la te d
t o
o th e r
v a ria b le s .
I
fin d
som e
e v id e n c e
o f
a
y ie ld -
re la te d
b ia s ,
b u t
it a c c o u n ts
fo r
o n ly
a sm all
p ro p o rtio n
o f th e
v a ria tio n
in
th e
im p lied
v o la tilitie s .
F in a lly .
I e x a m in e
th e
p ric in g
e r r o r s
a n d
s h o w
th a t
th e
m odel
p erfo rm s
w e ll
o n
a v e ra g e .
T he
a v e ra g e
p ric in g
e rro r
is on
th e
o rd e r
o f
2 %
fo r
c a ll
o p tio n s
a n d
6 %
fo r
p u t
o p tio n s .
S e c tio n
2 presents
th e
v a lu a tio n
m o d e l,
d e riv e s
c lo se d -fo rm
e x p re s s io n s
fo r
y ie ld -o p tio n
p ric e s ,
a n d
d is c u s s e s
th e ir
a n a ly tic a l
p ro p e rtie s .
S e c tio n
3
d e -
s c rib e s
th e
d a ta .
S e c tio n
4
p re s e n ts
th e
e m p iric a l
r e s u lts .
S e c tio n
5
sum m a-
riz e s
th e
r e s u lts
a n d
m akes
c o n c lu d in g
rem arks.
2 .
Y ie ld
o p tio n
p ric e s
In
th is
s e c tio n ,
I d e riv e
c lo se d -fo rm
e x p re s s io n s
fo r
E u ro p e a n
y ie ld
o p tio n
v a lu e s
u s in g
th e
g e n e ra l-e q u ilib riu m
term -stru ctu re
m odel
o f
C ox.
In g e rso ll.
a n d
R oss
(1 9 8 5 b ).
In
th is
m o d e l,
d is c o u n t
b o n d
p ric e s
a n d
y ie ld s
a re
o b ta in e d
b y
s p e c ia liz in g
th e
in te rte m p o ra l
g e n e ra l-e q u ilib riu m
a s s e t-p ric in g
m odel
o f
C ox,
In g e rso ll,
a n d
R oss
(1 9 8 5 a )
t o
a
s in g le -s ta te -v a ria b le
s e ttin g
in
w h ic h
e x p e c te d
p ro d u c tio n
re tu rn s
a n d
re tu rn
v a ria n c e s
a re
p ro p o rtio n a l
t o
a
fundam ental
s ta te
v a ria b le
d e s ig n a te d
X .
In
a d d itio n ,
th e
re p re s e n ta tiv e
in v e s to r
is
assum ed
t o
h a v e
tim e -a d d itiv e
s ta te -in d e p e n d e n t
lo g a rith m ic
p re fe re n c e s
a n d
th e
s ta te
v a ria b le
is assum ed
t o
fo llo w
a s in g u la r
s q u a re
ro o t
d iffu sio n
p ro c e s s
o f
th e
ty p e
s tu d ie d
b y
F e lle r
(1 9 5 1 ).
L et
Y r
d e n o te
th e
y ie ld
t o
m atu rity
fo r
d is c o u n t
b o n d s
w ith
a
c o n s ta n t
m atu rity
o f
T .
In
th is
fram ew ork,
th e
d y n a m ic s
o f
th e
econom y
a re
tim e-
hom ogeneous.
T h u s ,
w ith o u t
lo s s
o f
g e n e ra lity ,
Id e s ig n a te
th e
c u rre n t
tim e
a s
tim e
z e ro .
F u rth e rm o re ,
fo r
n o ta tio n a l
c o n v e n ie n c e .
I d e n o te
th e
tim e
r
v a lu e
o f th e
T -m atu rity
y ie ld
[Y ,(t)]
sim p ly
a s
Y r
w hen
th e
v a lu e
o f
r is c le a r
fro m
th e
c o n te x t.
C ox,
In g e rso ll,
a n d
R oss
s h o w
th a t
th e
y ie ld
o n
in s ta n ta -
n e o u s ly
m a tu rin g
b o n d s
Y ,
is
p ro p o rtio n a l
t o
X .
a n d
u se
th is
p ro p e rty
t o
m ake
a change
o f v a ria b le s
fro m
X
t o
Y ,,. T h e
re s u ltin g
e q u ilib riu m
dynam -
ics for
Y ,
c a n
b e
w ritte n
in
th e
fo rm
dY ,, =
( a
-
K Y ,)
d t
+
f lf i
dZ ,
(1 1
w here
(Y ,K ,
a n d
(T \u2019
a re
p o s itiv e
c o n s ta n ts .
T he
param eter
(Y corresponds
t o
th e
te r m
~ 0
in
C ox,
In g e rso ll,
a n d
R o ss\u2019
(1 9 8 5 b )
e q .
17. W e
u se
th is
sim pler
n o ta tio n
t o
c o n fo rm
m o re
c lo s e ly
t o
F e lle r
(1 9 5 1 ).
w ho
show s
th a t
th e
b e h a v io r
o f
th e
p ro c e s s
a s
it
a p p ro a c h e s
th e
s in g u la rity
a t
z e ro
is
g o v e rn e d
e n tire ly
b y
th e
re la tio n
b e tw e e n
th e
param eters
(Y and
u \u2019
a n d
is in d e p e n d e n t
o f
K .
T he
T -m atu rity
y ie ld
c a n
b e
e x p re s s e d
a s
y T = A (T )
+ B (T )Y ,.
(2 )
of 00

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