Pricing American Interest Rate Options Under the Jump-Extended Constant-Elasticity-of-Variance Short Rate Models

49 Pages Posted: 27 Jan 2011 Last revised: 15 Aug 2019

See all articles by Natalia Beliaeva

Natalia Beliaeva

Suffolk University - Department of Finance

Sanjay K. Nawalkha

University of Massachusetts Amherst - Isenberg School of Management

Date Written: June 14, 2011

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, Pan, and Singleton (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

JEL Classification: G12, G13, C15

Suggested Citation

Beliaeva, Natalia and Nawalkha, Sanjay K., Pricing American Interest Rate Options Under the Jump-Extended Constant-Elasticity-of-Variance Short Rate Models (June 14, 2011). Available at SSRN: https://ssrn.com/abstract=1748185 or http://dx.doi.org/10.2139/ssrn.1748185

Natalia Beliaeva

Suffolk University - Department of Finance ( email )

8 Ashburton Place-Beacon Hill
Boston, MA 02108-2770
United States

Sanjay K. Nawalkha (Contact Author)

University of Massachusetts Amherst - Isenberg School of Management ( email )

Amherst, MA 01003-4910
United States
413-687-2561 (Phone)

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