A Moment Matching Method for Option Pricing under Stochastic Interest Rates

Abstract

In this paper we present a simple, but new, approximation methodology for pricing a call option in a Black & Scholes market characterized by stochastic interest rates. The method, based on a straightforward Gaussian moment matching technique applied to a conditional Black & Scholes formula, is quite general and it applies to various models, whether affine or not. To check its accuracy and computational time, we implement it for the CIR interest rate model correlated with the underlying, using the Monte Carlo simulations as a benchmark. The method's performance turns out to be quite remarkable, even when compared with analogous results obtained by the affine approximation technique presented in and by the expansion formula introduced in , as we show in the last section.

Keywords: Option pricing, Stochastic interest rates, Moment matching, Non-affine models, Cox-Ingersoll-Ross model

JEL Classification: c00