On the American Swaption in the Linear-Rational Framework

Damir Filipovic and Yerkin Kitapbayev
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Damir Filipovic: Ecole Polytechnique Fédérale de Lausanne and Swiss Finance Institute
Yerkin Kitapbayev: Boston University

No 16-44, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

Abstract: We study American swaptions in the linear-rational term structure model introduced in Filipovic, Larsson, and Trolle (2016). The American swaption pricing problem boils down to an optimal stopping problem that is analytically tractable. It reduces to a free-boundary problem that we tackle by the local time-space calculus of Peskir (2005). We characterize the optimal stopping boundary as the unique solution to a nonlinear integral equation that can be readily solved numerically. We obtain the arbitrage-free price of the American swaption and the optimal exercise strategies in terms of swap rates for both fixed-rate payer and receiver swaps.

Keywords: American swaption; swaption; swap; linear-rational term structure model; polynomial diffusion; optimal stopping; free-boundary problem; local time-space calculus; integral equation (search for similar items in EconPapers)
JEL-codes: G12 G13 (search for similar items in EconPapers)
Pages: 20 pages
Date: 2016-07
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Persistent link: https://EconPapers.repec.org/RePEc:chf:rpseri:rp1644

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