VALUING EARLY-EXERCISE INTEREST-RATE OPTIONS WITH MULTI-FACTOR AFFINE MODELS

Sebastian Jaimungal () and Vladimir Surkov ()
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Sebastian Jaimungal: Department of Statistical Sciences, University of Toronto, 100 St. George Street, Toronto ON M5S 3G3, Canada
Vladimir Surkov: The Fields Institute for Research in Mathematical Sciences, University of Toronto, 222 College Street, Toronto ON M5T 3J1, Canada;

International Journal of Theoretical and Applied Finance (IJTAF), 2013, vol. 16, issue 06, 1-29

Abstract: Multi-factor interest-rate models are widely used. Contingent claims with early exercise features are often valued by resorting to trees, finite-difference schemes and Monte Carlo simulations. When jumps are present, however, these methods are less effective. In this work we develop an algorithm based on a sequence of measure changes coupled with Fourier transform solutions of the pricing partial integro-differential equation to solve the pricing problem. The new algorithm, which we call the irFST method, also neatly computes option sensitivities. Furthermore, we are also able to obtain closed-form formulae for accrual swaps and accrual range notes. We demonstrate the versatility and precision of the method through numerical experiments on European, Bermudan and callable bond options, accrual swaps and accrual range notes.

Keywords: Interest-rate derivatives; affine models; Fourier space-time stepping; accrual swaps; range notes (search for similar items in EconPapers)
Date: 2013
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Citations: View citations in EconPapers (2)

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DOI: 10.1142/S0219024913500349

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