ABSTRACT
This chapter shows that the “power” of the Heath, Jarrow, and Morton model by pricing interest rate exotic options. These interest rate options are called exotic because they are more complex than ordinary call and put options. Digital options are used because they provide similar “insurance” to caps and floors, but they are cheaper. Range notes provide a partial hedge for floating rate loans with caps and floors attached. Digital options are used in the market because they provide similar “insurance” to call and put options, but they are much cheaper to purchase. Digitals are cheaper because their payoffs are constant, and they do not increase linearly with the underlying’s value. Index-amortizing swaps are interest rate swaps in which the principal declines when interest rates decline. The procedure requires a detailed specification of the interest rate option’s cash flows given an evolution of the term structure of interest rates.
