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Pricing American Interest Rate Options in a Heath-Jarrow-Morton Framework Using Method of Lines

We consider the pricing of American bond options in a Heath-Jarrow-Morton framework in which the forward rate volatility is a function of time to maturity and the instantaneous spot rate of interest. We have shown in Chiarella and El-Hassan (1996) that the resulting pricing partial differential operators are two dimensional in the spatial variables. In this paper we investigate an efficientnumerical method to solve there partial differential equations for American option prices and the corresponding free exercise surface. We consider in particular the method of lines which other investigators (eg Carr and Faguet (1994) and Van der Hoek and Meyer (1997)) have found to be efficient for American option pricing when there is one spatial variable. In extending this method for the two dimensional case, we solve the pricing equation by discretising the time variable and one state varialbe and using the spot rate of interest as a continuous variable. We compare our method with the lattice method of Li, Ritchken and Sankarasubramanian (1995).

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File URL: http://www.qfrc.uts.edu.au/research/research_papers/rp12.pdf
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Paper provided by Quantitative Finance Research Centre, University of Technology, Sydney in its series Research Paper Series with number 12.

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Length: 19 pages
Date of creation: 01 Aug 1999
Date of revision:
Handle: RePEc:uts:rpaper:12
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  1. Carl Chiarella & Oh Kwon, 2003. "Finite Dimensional Affine Realisations of HJM Models in Terms of Forward Rates and Yields," Review of Derivatives Research, Springer, vol. 6(2), pages 129-155, May.
  2. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "A Theory of the Term Structure of Interest Rates," Econometrica, Econometric Society, vol. 53(2), pages 385-407, March.
  3. Ram Bhar & Carl Chiarella, 1995. "Transformation of Heath-Jarrow-Morton Models to Markovian Systems," Working Paper Series 53, Finance Discipline Group, UTS Business School, University of Technology, Sydney.
  4. Heath, David & Jarrow, Robert & Morton, Andrew, 1992. "Bond Pricing and the Term Structure of Interest Rates: A New Methodology for Contingent Claims Valuation," Econometrica, Econometric Society, vol. 60(1), pages 77-105, January.
  5. Brennan, Michael J. & Schwartz, Eduardo S., 1979. "A continuous time approach to the pricing of bonds," Journal of Banking & Finance, Elsevier, vol. 3(2), pages 133-155, July.
  6. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
  7. Li, Anlong & Ritchken, Peter & Sankarasubramanian, L, 1995. " Lattice Models for Pricing American Interest Rate Claims," Journal of Finance, American Finance Association, vol. 50(2), pages 719-37, June.
  8. Carl Chiarella & Nadima El-Hassan, 1997. "Evaluation of Derivative Security Prices in the Heath-Jarrow-Morton Framework as Path Integrals Using Fast Fourier Transform Techniques," Working Paper Series 72, Finance Discipline Group, UTS Business School, University of Technology, Sydney.
  9. Inui, Koji & Kijima, Masaaki, 1998. "A Markovian Framework in Multi-Factor Heath-Jarrow-Morton Models," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 33(03), pages 423-440, September.
  10. Andrew Carverhill, 1994. "When Is The Short Rate Markovian?," Mathematical Finance, Wiley Blackwell, vol. 4(4), pages 305-312.
  11. Michael J. Brennan and Eduardo S. Schwartz., 1979. "A Continuous-Time Approach to the Pricing of Bonds," Research Program in Finance Working Papers 85, University of California at Berkeley.
  12. Carl Chiarella & Nadima El-Hassan, 1996. "A Preference Free Partial Differential Equation for the Term Structure of Interest Rates," Working Paper Series 63, Finance Discipline Group, UTS Business School, University of Technology, Sydney.
  13. Robert C. Merton, 1973. "Theory of Rational Option Pricing," Bell Journal of Economics, The RAND Corporation, vol. 4(1), pages 141-183, Spring.
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