20-Term Structure Page 593 Wednesday, February 4, 2004 1:33 PM

CHAPTER

20

Term Structure Modeling and

Valuation of Bonds and

Bond Options

I

n this chapter we introduce the concepts and mathematical technology

of bond and bond option valuation. We will begin by analyzing the

behavior of bond prices in a deterministic interest rate environment

(i.e., assuming that interest rates are known at every future date). We

will then move on to a full stochastic description of interest rates and of

the term structure of interest rates and will tackle bond and bond option

valuation problems in this environment.

The term structure of interest rates plays a key role in financial decision-

making and investment management. Richard McEnally and James Jordan^1

provide the following list of uses for the term structure of interest rates:

■ Analyzing the potential returns for investments with different maturi-

ties.

■ Assessing market consensus expectations of future interest rates.

■ Pricing bonds and other fixed-income contractual obligations.

■ Pricing contingent claims in which the underlying is a fixed-income

security.

■ Arbitraging between bonds with different maturities.

■ Forming expectations about the economy (e.g., economic activity and

inflation).

(^1) Richard W. McEnally and James V. Jordan, “The Term Structure of Interest
Rates,” Chapter 43 in Frank J. Fabozzi (ed.), The Handbook of Fixed Income Secu-
rities: Fifth Edition (Chicago: Irwin Professional Publishing, 1997), pp. 818–822.
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