Efficient Trees for CIR and CEV Short Rate Models
39 Pages Posted: 29 Mar 2007
Date Written: February 2007
This paper presents efficient binomial and trinomial trees for the Cox, Ingersoll, and Ross (CIR) and the constant-elasticity-of-variance (CEV) short rate models. We correct an error in the original square root transform of Nelson and Ramaswamy , and modify their transform by truncating the tree exactly at the zero-boundary. This not only allows us to create computationally more efficient trees for the CIR square-root process, but also for the entire class of CEV models of the short rate. Our simulations show fast convergence and significantly improved performance of the truncated-tree approach over the Nelson-Ramaswamy approach.
Keywords: Trees, Binomial, Trinomial, American options, CIR, Cox Ingersoll and Ross, Constant Elasticity of Variance, Short rate, caps, interest rate
JEL Classification: G0, G10, G11, G12, G21
Suggested Citation: Suggested Citation