On Errors and Bias of Fourier Transform Methods in Quadratic Term Structure Models
29 Pages Posted: 10 Jan 2006
Date Written: January 9, 2006
We analyze and compare the performance of the Fourier transform method in affine and quadratic term structure models. We explain why the method of the reduction to FFT in dimension one is efficient for ATSMs of type $A_0(n)$ but may lead to sizable errors for QTSMs unless computational errors are taken into account properly. We suggest a certain improvement and generalization which make FFT more accurate and, for the same precision, faster than Leippold and Wu (2002) method. We deduce simple general recommendations for the choice of parameters of computational schemes for QTSMs, which ensure a given precision, and an approximate formula for the bias which FFT produces.
Keywords: Derivative pricing, quadratic term structure models, Fourier transform, Fast Fourier transform
JEL Classification: C60, C69
Suggested Citation: Suggested Citation