A Dynamic Programming Approach for Pricing Options Embedded in Bonds
AbstractThe aim of this paper is to price options embedded in bonds in a Dynamic Programming (DP) framework, the focus being on call and put options with advance notice. The pricing of interest rate derivatives was usually done via trees or finite differences. Trees are not really very efficient as they deform crudely the dynamic of the underlying asset(s), here the short term risk-free interest rate. They can be interpreted as elementary DP procedures with fixed grid sizes. For a long time, finite differences presented poor accuracy because of the discontinuities of the bond's value that may arise at decision dates. Recently, remedies were given by d'Halluin et al (2001) via techniques related to flux limiters. DP does not suffer from discontinuities that may arise at decision dates and does not require a time discretization. It may also be implemented in discrete-time models. Results show efficiency and robustness. Suggestions to combine DP and finite differences are also formulated
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Bibliographic InfoPaper provided by Society for Computational Economics in its series Computing in Economics and Finance 2004 with number 237.
Date of creation: 11 Aug 2004
Date of revision:
Dynamic Programming; Stochastic Processes; Options Embedded in Bonds; American Options;
Find related papers by JEL classification:
- C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
This paper has been announced in the following NEP Reports:
- NEP-ALL-2004-08-16 (All new papers)
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