The Direct Approach to Debt Option Pricing

We review the continuous{time literature on the so{called direct
approach to bond option pricing. Going back to Ball and Torous
(1983), this approach models bond price processes directly (i.e.
without reference to interest rates or state variable processes)
and applies methods that Black and Scholes (1973) and Merton (1973)
had originally developed for stock options. We describe the
principal modelling problems of the direct approach and compare in
detail the solutions proposed in the literature