The Pricing of Equity-Linked Contingent Claims Under a Lognormal Short Rate Dynamics
Posted: 14 Apr 2011
Date Written: April 12, 2011
We propose a numerical procedure for the pricing of financial contracts whose contingent claims are exposed to two sources of risk: the stock price and the short interest rate. More precisely, in our pricing framework we assume that the stock price dynamics is described by the Cox, Ross Rubinstein (CRR, 1979) binomial model under a stochastic risk free rate, whose dynamics evolves over time accordingly to the Black, Derman and Toy (BDT, 1990) one-factor model. To this aim, we set the hypothesis that the instantaneous correlation between the trajectories of the future stock price (conditional on the current value of the short rate) and of the future short rate is zero and we therefore show that the hypothesis of absence of instantaneous correlation between the two mentioned risk factors does not necessarily imply that also their terminal correlation is zero. We then apply the resulting stock price dynamics to evaluate the price of a simple contract, i.e. of a stock option. Finally, we compare the derived price to the price of the same option under different pricing models, as the traditional Black and Scholes (1973) model. We expect that, the difference in the two prices is not sensibly large. We conclude showing in which cases it should be helpful to adopt the described model for pricing purposes.
Keywords: option pricing, stochastic short rate model, binomial tree
JEL Classification: C63, C65, G13
Suggested Citation: Suggested Citation