Evaluating callable and putable bonds: An eigenfunction expansion approach

Dongjae Lim, Lingfei Li and Vadim Linetsky

Journal of Economic Dynamics and Control, 2012, vol. 36, issue 12, 1888-1908

Abstract: We propose an efficient method to evaluate callable and putable bonds under a wide class of interest rate models, including the popular short rate diffusion models, as well as their time changed versions with jumps. The method is based on the eigenfunction expansion of the pricing operator. Given the set of call and put dates, the callable and putable bond pricing function is the value function of a stochastic game with stopping times. Under some technical conditions, it is shown to have an eigenfunction expansion in eigenfunctions of the pricing operator with the expansion coefficients determined through a backward recursion. For popular short rate diffusion models, such as CIR, Vasicek, 3/2, the method is orders of magnitude faster than the alternative approaches in the literature. In contrast to the alternative approaches in the literature that have so far been limited to diffusions, the method is equally applicable to short rate jump–diffusion and pure jump models constructed from diffusion models by Bochner's subordination with a Lévy subordinator.

Keywords: Interest rate models; Callable bonds; Options embedded in bonds; Optimal stopping; Stochastic games; Eigenfunction expansions; Option pricing; Stochastic time changes (search for similar items in EconPapers)
JEL-codes: C63 G13 (search for similar items in EconPapers)
Date: 2012
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (13)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:dyncon:v:36:y:2012:i:12:p:1888-1908

DOI: 10.1016/j.jedc.2012.06.002

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