AN ANALYTICAL APPROXIMATION FOR EUROPEAN OPTION PRICES UNDER STOCHASTIC INTEREST RATES

Hideharu Funahashi ()
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Hideharu Funahashi: Mizuho Securities Co. Ltd., Otemachi First Square 1-5-1, Otemachi, Chiyoda-ku, Tokyo 100-0004, Japan;

International Journal of Theoretical and Applied Finance (IJTAF), 2015, vol. 18, issue 04, 1-43

Abstract: This paper extends the Wiener–Itô chaos expansion approach proposed by Funahashi & Kijima (2015) to an equity-interest-rate hybrid model for the pricing of European contingent claims with special emphasis on calibration to the option markets. Our model can capture the volatility skew and smile of option markets, as well as the stochastic nature of interest rates. Further, the proposed method is applicable to widely used option pricing models such as local volatility models (LVM), stochastic volatility models (SVM), and their combinations with the stochastic nature of interest rates; hence, it is suitable for practical purposes. Through numerical examples, we show that our approximation is quite accurate even for long-maturity and/or high-volatility cases.

Keywords: Hybrid equity model; Hull–White model; local volatility model; Wiener–Itô chaos expansion (search for similar items in EconPapers)
Date: 2015
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Citations: View citations in EconPapers (1)

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DOI: 10.1142/S0219024915500260

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