Goldman Sachs needed a better model of the embedded bond option, and valuing fixed income derivative products. This need was brought to Fischer’s attention, and he came up with the Black-Derman-Toy (BDT) computer model, which was later published in 1990. The BDT model worked much better than Black Scholes when it came to valuing bond options. Fischer was able to develop BDT quickly because he had been thinking about it since he attended Modigliani’s talk’s years ago. Modigliani expressed that the most important thing missing from an ideal pricing model was the implementation of risk and uncertainty.
Richard Roll was hired by Goldman Sachs to build a Mortgage Security Research capability within the Fixed Income Division; he tried to utilize CAPM to build the model. Years later, Roll and Fischer met and were able to analyze Roll’s empirical model and Fischer’s more theoretical BDT model. Fischer agreed that BDT had a few problems from the trader’s perspective, and portrayed an unrealistically high equilibrium. However, BDT worked well for firms to price custom options, and to calculate the correct hedge.
In a paper, Fischer explained the constant upward slope of the term structure can be clarified by viewing interest rates as options.
A for Rooster.
ReplyDeleteWhat's going on in this section is the break down of what everyone thought was a simple idea: bonds.
Bonds have fixed coupons in textbooks. We also mention that many of them are callable, but don't go forward with that idea until later classes.
That callability makes what appear to be plain vanilla bonds into more complex options. So, the discussion in this chapter could be analyzed using the binomial pricing tools you learned this semester.