Application of the Heath–Platen estimator in the Fong–Vasicek short rate model

Sema Coskun, Ralf Korn and Sascha Desmettre

Journal of Computational Finance

Abstract: Due to the presence of stochastic volatility dynamics, the Fong–Vasicek (FV) short rate model is more complex but also more realistic than the classical Vasicek version. To enhance the numerical tractability of the FV model for the calculation of bond option prices, we suggest using the Heath–Platen (HP) estimator, which performs excellently in the related Heston stochastic volatility model. We show that the HP estimator reduces the variance, and thus the size, of confidence intervals dramatically compared with a crude Monte Carlo estimation, which leads to a drastic speed-up in price calculations across different ;realistic parameter sets.

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