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Pricing American interest rate options under the jump-extended constant-elasticity-of-variance short rate models

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  • Beliaeva, Natalia
  • Nawalkha, Sanjay
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    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 et al., 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.

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Banking & Finance.

    Volume (Year): 36 (2012)
    Issue (Month): 1 ()
    Pages: 151-163

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    Handle: RePEc:eee:jbfina:v:36:y:2012:i:1:p:151-163

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    Web page: http://www.elsevier.com/locate/jbf

    Related research

    Keywords: CEV short rate models; American interest rate options; CIR short rate model; Jump-diffusion processes; Longstaff and Schwartz LSM approach;

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    Cited by:
    1. Chung, San-Lin & Shih, Pai-Ta & Tsai, Wei-Che, 2013. "Static hedging and pricing American knock-in put options," Journal of Banking & Finance, Elsevier, vol. 37(1), pages 191-205.

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