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Pricing American interest rate options under the jump-extended constant-elasticity-of-variance short rate models

Natalia Beliaeva and Sanjay Nawalkha

Journal of Banking & Finance, 2012, vol. 36, issue 1, 151-163

Abstract: This paper demonstrates how to value American interest rate options under the jump-extended constant-elasticity-of-variance (CEV) models. We consider both exponential jumps (see Duffie et al., 2000) and lognormal jumps (see Johannes, 2004) in the short rate process. We show how to superimpose recombining multinomial jump trees on the diffusion trees, creating mixed jump-diffusion trees for the CEV models of short rate extended with exponential and lognormal jumps. Our simulations for the special case of jump-extended Cox, Ingersoll, and Ross (CIR) square root model show a significant computational advantage over the Longstaff and Schwartz’s (2001) least-squares regression method (LSM) for pricing American options on zero-coupon bonds.

Keywords: CEV short rate models; American interest rate options; CIR short rate model; Jump-diffusion processes; Longstaff and Schwartz LSM approach (search for similar items in EconPapers)
JEL-codes: G12 G13 C15 (search for similar items in EconPapers)
Date: 2012
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Handle: RePEc:eee:jbfina:v:36:y:2012:i:1:p:151-163