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Apart from classical Black-Scholes model which assumes that forward interest rate is (log) normally distributed, what kind of pricing tools can we use as a buy side? We have good estimation on how interest term structure evolves. Moreover, the underlying interest rate is discrete with minimal changing 5 basis point.

First, it is interest rate options including swaptions, cap and floor. I want to price the options given my opinions on interest trend. As a major market player we have clear views on how the interest will evolve. Last, the underlying interest rate is set by central bank with 5 basis point minimum change. For example, it could be 4.25% or 4.20% but never 4.21%. I have finished learning most risk neutral pricing methods and want to know how to combine our points of view on how the interest rate evolve into those models.

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  • $\begingroup$ I would recommend you edit your question as it is not clear to me what you want to achieve. What kind of interest rate options? what is it that you want to achieve and what is behind your statement "the underlying interest rate is discrete with minimal changing 5 basis points" $\endgroup$ – PeacePanda Jan 30 '20 at 13:23
  • $\begingroup$ Thank you for your reply. First, it is interest rate options including swaptions, cap and floor. I want to price the options given my opinions on interest trend. As a major market player we have clear views on how the interest will evolve. Last, the underlying interest rate is set by central bank with 5 basis point minimum change. For example, it could be 4.25% or 4.20% but never 4.21%. I have finished learning most risk neutral pricing methods and want to know how to combine our points of view on how the interest rate evolve into those model. $\endgroup$ – Shong Rico Jan 31 '20 at 12:09
  • $\begingroup$ @ShongRico I think you can reformulate your question to address the basic issue, which is: if you have a view on the drift of the asset, and the underlying asset or future on asset is tradable, how can your take advantage of your view under the assumption that your view materialises. $\endgroup$ – Frido Rolloos Feb 3 '20 at 16:52
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Interest rate options should be priced with risk neutral methods regardless of your opinion of interest rate trends. If you have a view on interest rates, you can express it by taking a delta position. If you were to bias your option prices , you would just end up paying the wrong price for the option.

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  • $\begingroup$ Good answer, indeed if you have a view on trend (drift) then adjust your delta hedge. $\endgroup$ – Frido Rolloos Feb 3 '20 at 16:47

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