The Pricing of Option on Bond Forwards

We derive closed-form solutions for the equilibrium prices of bonds, bond forwards, bond futures, options on the bond forwards and options on the bond futures when the interest rate is stochastic. The prices of options on the bond forwards are shown to be greater than the prices of option on the corresponding bond futures

Time Complementarity and the Behavior of Asset Returns

The testable restrictions on the behavior of asset returns are investigated when variable time preference exhibits time complementarity. It is shown that as time complementarity (i.e., temporal risk preference) increases, the volatility of asset prices increases. It is also shown that time complementarity helps explain excessively volatile asset returns and excessively smooth consumption growth. Our empirical study confirms this result. Variable time preference exhibiting time complementarity improves the overall fitness but there is a substantial evidence when the restrictions are imposed simultaneously for different assets. Consumption from services appears to be a major source of the empirical puzzles documented in the literature

The Monetary Policy Rule in Australia: Does the RBA Target Inflation Only?

This paper estimates a simple monetary policy reaction function for Australia. Although the reaction function is rather simple, it is shown to be able to capture the essential elements across different policy regimes. The empirical findings mostly corroborate the RBAs own claims made through Reserve Bank Report and Financial Statements. During the pre-inflation targeting period (1985-1992), the RBA targeted external factors such as the current account deficit and the Federal Funds Rate, in addition to inflation. Over time, the policy focus has, however, become directed explicitly towards price stability. During the post announcement period (1990-1999), the RBA targeted only future inflation up to one-year ahead. As the forecast horizon became longer than one year, however, the RBA targeted short-run output fluctuations in order to allow medium-run expected inflation to adjust rather slowly to the medium-run target. The results show that, in a flexible inflation targeting regime, medium-term price stability can be maintained while allowing some scope for targeting output variability

An Exact Pricing Error of the APT within the Arbitrage Framework

We derive an exact deviation for an individual asset from APT Pricing in a finite economy within the arbitrage framework. This deviation is the product of a tradeoff between mean and variance of the efficient arbitrage portfolio, the asset's idiosyncratic variance and the proportion of this arbitrage portfolio represented by the asset. We show that the deviation becomes negligible in an infinite economy if the efficient portfolio is well diversified

Pricing Call Options under Stochastic Volatilities

This paper derives a closed-form solution for the European call option price when the volatility of the underlying stock returns is governed by a diffusion process. The model uses the continuity property of a diffusion process and the martingale approach to valuation of assets under no arbitrage. The pricing formula differs from the Black-Scholes formula in that it needs a volatility adjustment. The volatility movement is allowed to be contemporaneously correlated with the stock price movement