A Simple Induction Approach and an Efficient Trinomial Lattice for Multi-State Variable Interest Rate Derivatives Models

A Simple Induction Approach and an Efficient Trinomial Lattice for Multi-State Variable Interest... This paper presents an alternative approach for interest rate lattice construction in the Ritchken and Sankarasubramanian (1995) framework. The proposed method applies a parsimonious induction technique to represent the distribution of auxiliary state variables and value interest rate derivatives. In contrast to other approaches, this technique requires no numerical interpolations, approximations and iterative procedures for pricing interest rate options using a simple backward induction and, therefore, provides significant computational advantages and flexibility with respect to existing implementations. Also, the proposed trinomial interest rate lattice specification provides for a further reduction in computational costs with additional flexibility. The results of this work can be extended to a class of derivatives pricing models with path dependent state variables and generalized to multi-factor models. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Review of Quantitative Finance and Accounting Springer Journals

A Simple Induction Approach and an Efficient Trinomial Lattice for Multi-State Variable Interest Rate Derivatives Models

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Publisher
Springer Journals
Copyright
Copyright © 2005 by Springer Science + Business Media, Inc.
Subject
Finance; Corporate Finance; Accounting/Auditing; Econometrics; Operation Research/Decision Theory
ISSN
0924-865X
eISSN
1573-7179
D.O.I.
10.1007/s11156-005-6337-y
Publisher site
See Article on Publisher Site

Abstract

This paper presents an alternative approach for interest rate lattice construction in the Ritchken and Sankarasubramanian (1995) framework. The proposed method applies a parsimonious induction technique to represent the distribution of auxiliary state variables and value interest rate derivatives. In contrast to other approaches, this technique requires no numerical interpolations, approximations and iterative procedures for pricing interest rate options using a simple backward induction and, therefore, provides significant computational advantages and flexibility with respect to existing implementations. Also, the proposed trinomial interest rate lattice specification provides for a further reduction in computational costs with additional flexibility. The results of this work can be extended to a class of derivatives pricing models with path dependent state variables and generalized to multi-factor models.

Journal

Review of Quantitative Finance and AccountingSpringer Journals

Published: Jan 1, 2005

References

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