American Bond Option Pricing in One-Factor Dynamic Term Structure Models

Arbitrage-free pricing of American options on bonds in one-factor dynamic term structure models is investigated. We re-derive a general decomposition result which states that the American bond option premium can be split into the value of an otherwise equivalent European option and an early exercise premium. This extends earlier work on American equity options by e.g. Kim (1990), Jamshidian (1992) and Carr, Jarrow, and Myneni (1992) and parallels recent work by Jamshidian (1991, 1992, 1993) and Chesney, Elliott, and Gibson (1993). We examine a Gaussian class of special cases in some detail and provide a variety of numerical valuation results