Chapter 18

Fixed Income Options

This chapter discusses some of the most popular fixed income options, namely, caps and floors, swaptions, bond options, Eurodollar (ED) and Euribor futures options, and bond futures options. These options can be, and some often are, priced using the term structure models of Part Three. When the objective is not to compute relative cheapness or richness, however, but to interpolate between known market prices or to calculate hedge ratios, practitioners often take the much simpler approach of using some form of the Black-Scholes (BS) option pricing model.

First, the chapter describes the fixed income options listed in the previous paragraph. The practice of applying BS in each context is explained, and the less justifiable practices critiqued in favor of other methodologies. For easy reference, common practitioner applications of BS are collected and summarized in Tables 18.8 through 18.10.

The chapter focuses next on the skew, the fact that BS implied volatilities vary with strike. The existence of the skew means that the BS model, even when applied to European-style options of a single maturity, cannot capture the richness of option prices in the market. The section on skew focuses on swaptions and presents two commonly used approaches to model the skew.

The final section of the chapter presents the theory that justifies the application of BS to the fixed income options described in this chapter. Consistent with the rest of this book, every effort ...

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