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Lattice methods for no-arbitrage pricing of interest rate securities

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  • Daglish, Toby

Abstract

We explore calibration of single factor no-arbitrage short rate models to yield and volatility information. We note that the calculation of Arrow-Debreu prices for interest rate securities is analogous to solving the Kolmogorov Forward Equation. This insight allows us to implement implicit methods which exhibit more rapid convergence than explicit methods. We develop an algorithm for calibrating a model to match both yield and volatility curves which is general across single factor short rate models and also across finite difference techniques. Numerical examples confirm that our approach vastly improves computation times for derivative pricing.

Suggested Citation

  • Daglish, Toby, 2010. "Lattice methods for no-arbitrage pricing of interest rate securities," Working Paper Series 19153, Victoria University of Wellington, The New Zealand Institute for the Study of Competition and Regulation.
    • Handle: RePEc:vuw:vuwcsr:19153
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    File URL: https://ir.wgtn.ac.nz/handle/123456789/19153
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    1. Yoosef Maghsoodi, 1996. "Solution Of The Extended Cir Term Structure And Bond Option Valuation," Mathematical Finance, Wiley Blackwell, vol. 6(1), pages 89-109, January.
    2. Ho, Thomas S Y & Lee, Sang-bin, 1986. "Term Structure Movements and Pricing Interest Rate Contingent Claims," Journal of Finance, American Finance Association, vol. 41(5), pages 1011-1029, December.
    3. Chan, K C, et al, 1992. "An Empirical Comparison of Alternative Models of the Short-Term Interest Rate," Journal of Finance, American Finance Association, vol. 47(3), pages 1209-1227, July.
    4. Hull, John & White, Alan, 1990. "Pricing Interest-Rate-Derivative Securities," The Review of Financial Studies, Society for Financial Studies, vol. 3(4), pages 573-592.
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