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Introduction to IRO Options

The IRO component is designed to deal with a range of derivative instruments whose values are primarily dependent on changes in interest rates. The supported functions can be usefully split into two categories:

 

Log-Normal Model: For European style options where the underlying variable is assumed to have a log-normal distribution. The underlying might be an interest rate, yield, par swap rate, or bond price. In all of these cases, the option is valued using a variant of the Black (1976) model.

 

Term Structure Models: Bermudan and American style interest sensitive options are reliant on different interest rates at different points of time, and appropriate valuation models must therefore deal with the entire term structure of interest rates. Bermudan and American style instruments such as callable/puttable bonds, bond options, and swaptions can be valued using the following models:

 

  • Black-Derman-Toy (1990)
  • Hull and White (1993)
  • Ho and Lee (1986)
  • Black and Karasinski (1991)

 

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