Valuation of an Option to Exchange one Powered Bond for Another

Bond markets are over the counter markets, plagued with illiquidity, price volatility, mispricing, sovereign restructuring issues and other difficulties. We price powered bonds based on an interest rate term structure of a stochastic strings model. Power exchange bond options resolve issues associated with general bond risk management. We obtain closed-form expressions for pricing and hedging bond power exchange options. Sufficient conditions for the equivalence of the European and the American versions of bond power exchange options are provided. The put-call parity relation for this kind of option is also stated. We show connections with standard bond option pricing models and explain the superiority of our model. Finally, we consider several applications of our results including duration and convexity measures for bond power exchange options, pricing extendable/accelerable maturity zero-coupon bonds, options to price a zero-coupon bond off of a shifted term-structure, and options on interest rates and rate spreads