Interest Rate Options

Abstract

This chapter discusses interest rate options. Given an underlying asset, derivatives or contingent claims are contracts with specified payoffs based on the value of the underlying. The simplest contingent claim-after a forward contract-is a European-style option, which has a specified payoff at a single exercise time in the future. This chapter walks readers through the one-step binomial model before explaining how to account for the probability of arbitrage and risk-neutrality. Next, it demonstrates how to select state variables to ensure normal distribution. The second half of the chapter discusses how interest rate options work, including a description of the market players, options, futures, swaptions, and bond options.