Interest Rate Options Essay Example | Topics and Well Written Essays - 1000 words

Interest Rate Options - Essay Example As the paper delcares a common example of this bond is, the Treasury Bond Futures Option. Others are Treasury Notes Futures Options and Eurodollar Futures Options. The Treasury Bond Future Options is priced at 1/64th of 1% of the Treasury Bond face value; the Eurodollar Futures Bond is calculated at 0.01 basis point value being equivalent to $25. It is to be noted here that the interest rate futures prices are indirectly proportional to the bond price increases or decrease. This report discusses that Black’s model is a mutation from the Black Scholes Model, which uses the rate of interest as the base for pricing the options. The most important factor is that it functions on the assumptions that â€Å"a key market variable will be lognormally distributed at a future time†. When Black's model is used to value the price of European interest rate options, the worth of future price of V for a contract maturing at time T, is usually set equal to the forward price of V rather than its futures price. This is more theoretical than practical since in this case you will have to assume that the rates of interest also remain constant while discounting over the same period of future, which is definitely not the case. This is an option which has pre-determined selling price and time. This value is determined based on the Black’s Model assumptions, that the price is lognormal at the pre-fixed time in the future. The value of the bond option can be worked out with the following equations using the Black’s model which sets Fo equal to the forward bond price.