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Valuation of Path-Dependent Interest Rate Derivatives in a Finite Difference Setup

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Abstract

In this paper we study and implement a finite difference version of the augmented state variable approach proposed by Hull & White (1993) that allows for pathdependent securities. We apply the method to a class of path-dependent interest rate derivatives and consider several examples including mortgage backed securities and collateralized mortgage obligations. The efficiency of the method is assessed in a comparative study with Monte Carlo simulation and we find it to be faster for a similar accuracy.

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  • Svenstrup, Mikkel, 2003. "Valuation of Path-Dependent Interest Rate Derivatives in a Finite Difference Setup," Finance Working Papers 02-21, University of Aarhus, Aarhus School of Business, Department of Business Studies.
  • Handle: RePEc:hhb:aarfin:2002_021
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    1. Stanton, Richard & Wallace, Nancy, 1999. "Anatomy of an ARM: The Interest-Rate Risk of Adjustable-Rate Mortgages," The Journal of Real Estate Finance and Economics, Springer, vol. 19(1), pages 49-67, July.
    2. Schwartz, Eduardo S & Torous, Walter N, 1989. " Prepayment and the Valuation of Mortgage-Backed Securities," Journal of Finance, American Finance Association, vol. 44(2), pages 375-392, June.
    3. Stanton, Richard, 1995. "Rational Prepayment and the Valuation Mortgage-Backed Securities," Review of Financial Studies, Society for Financial Studies, vol. 8(3), pages 677-708.
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    Keywords

    Path-dependent Options; Finite Difference; Mortgage Backed Securities;

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