Pricing Interest Rate Exotics in Multi-Factor Gaussian Interest Rate Models

34 Pages Posted: 20 Oct 1998

See all articles by Les Clewlow

Les Clewlow

Lacima; University of Warwick - Financial Options Research Centre (FORC); University of Technology Sydney (UTS) - School of Finance and Economics

Chris Strickland

University of Technology Sydney (UTS)

Date Written: July 1998

Abstract

For many interest rate exotic options, for example options on the slope of the yield curve or American featured options, a one factor assumption for term structure evolution is inappropriate. These options derive their value from changes in the slope or curvature of the yield curve and hence are more realistically priced with multiple factor models. However, efficient construction of short rate trees becomes computationally intractable as we increase the number of factors and in particular as we move to non-Markovian models

In this paper we describe a general framework for pricing a wide range of interest rate exotic options under a very general family of multi-factor Gaussian interest rate models. Our framework is based on a computationally efficient implementation of Monte Carlo integration utilising analytical approximations as control variates. These techniques extend the analysis of Clewlow, Pang, and Strickland [1997] for pricing interest rate caps and swaptions.

JEL Classification: G13

Suggested Citation

Clewlow, Les and Strickland, Chris, Pricing Interest Rate Exotics in Multi-Factor Gaussian Interest Rate Models (July 1998). Available at SSRN: https://ssrn.com/abstract=128669 or http://dx.doi.org/10.2139/ssrn.128669

Les Clewlow

Lacima ( email )

London
United Kingdom

HOME PAGE: http://www.lacimagroup.com

University of Warwick - Financial Options Research Centre (FORC)

Coventry CV4 7AL
United Kingdom

HOME PAGE: http://www.wbs.ac.uk/expertise/research_teaching/f

University of Technology Sydney (UTS) - School of Finance and Economics ( email )

Haymarket
Sydney, NSW 2007
Australia

HOME PAGE: http://www.business.uts.edu.au/finance/

Chris Strickland (Contact Author)

University of Technology Sydney (UTS) ( email )

15 Broadway, Ultimo
Sydney 2007, New South Wales
Australia

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