Sorry, if it's a very rudimentary question. I mainly practice tax but have to deal with financial transactions from time to time where I have to benchmark option prices. I have usually used Hull's Derivagem (normal short-rate model) to calculate option prices on bonds. I have been assuming a flat term structure for simplicity.

However, I'm looking to relax this assumption and use a normal term structure. I have been told that the way term structure goes into Derivagem is as follows. For example, for a 10 year bond: at 1-year maturity, the bond has 9 years remaining until maturity, so we use a 9 year zero-coupon yield; at 2-year maturity, the has 8 years remaining until maturity, so we use a 8 year zero-coupon yield; and so and so forth.

This would give a term structure where yields will down as maturities go up. However, this is a bit counter intuitive to me. I thought we can derive a term structure by listing maturities in a chronological order and then the corresponding zero-coupon yields.

I'd really appreciate if someone could please clarify this concept for me.



Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Browse other questions tagged or ask your own question.