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On Errors And Bias Of Fourier Transform Methods In Quadratic Term Structure Models

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    (The University of Chicago Graduate School of Business, 5807 South Woodlawn Avenue, Chicago, IL 60637, USA)



    (Department of Economics, The University of Texas at Austin, 1 University Station C3100, Austin, TX 78712-0301, USA)

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 1 is efficient for ATSMs of type A0(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 the Leippold and Wu [M. Leippold and L. Wu, Option pricing under the quadratic class, Journal of Financial and Quantitative Analysis 37(2) (2002) 271–295] 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.

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Article provided by World Scientific Publishing Co. Pte. Ltd. in its journal International Journal of Theoretical and Applied Finance.

Volume (Year): 10 (2007)
Issue (Month): 02 ()
Pages: 273-306

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Handle: RePEc:wsi:ijtafx:v:10:y:2007:i:02:p:273-306
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