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# basu

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06/16/2009

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Approximatingpricesofbondswithlog-normal  interestrate
SankarshanBas
an
AngelosDassios
Abstrac
Keywords
Gaussianprocesses,log-normalinterestrates,Brownianmotion,OrnsteinUhlenbecprocess,bonds,option
AMS1991subjectclassication
90A09,60G1
1Introduction
Lettheinstantaneousrateofinteres
begivenby
b

wher
isaGaussianprocesswithzeromeanandavariance-covariancCov(
;
)

u

isthedriftof
an
isascalingfactorwhoseimportancewillbecomeapparentinthenext section.Inourexamplesitwillrepresentthevalueof
atspecictimepoints.Ourmodelcan beputintheframeworkoftheworksetoutbyHeath,JarrowandMorton(1992);seealsoBaxte
DepartmentOfStatisticsTheLondonSchoolofEconomicsandPoliticalScienceHoughtonStreetLondonWC2A2AE, U.K

andRennie(1996).ItisanextensionoftheworkbyBlackandKarasinski(1991),aswellasBlack, DermanandToy(1990).Whe

Z

d
)
wher
isaconvexfunction.Thus,inparticularthepriceofthebond(f(x)

b
)isgivenby


d
)(1andthevalueofthecontingentpayment(f(x)=

b

)isgivenby


d

(2RogersandShilookatf(x)
=max
x
0).Theyalsoassumetha
isaBrownianmotion. Tocalculatethepriceofthebondandcalloption,wemakeuseofaconditioningfactorZ.Aloweboundcanbeobtainedusingthefactthat
))
)

))
SeveralchoicesofZasaconditioningfactorhavebeentriedbyRogersandShi,aswellasus.Ifact,wehavefound,empirically,thatthebestchoiceofZ,inallcasesi
d
q
Va
d
.Zithiscasefollowsastandardnormaldistribution. Thedirectexpansionmethodusedinhereisonlyconcernedwiththecalculationofthepricesforthe bond.TheprimaryreasonforusingthetwomethodsisthatitprovidesameasureofcomparabilityInthevaluationofcontingentpaymentsontheinterestrate,thedirectmethodcannotbeusedand henceweresorttotheuseofsimulatedvaluestochecktheaccuracyoftheconditioning.
2Calculationsusingconditioning
Asmentionedabove,weconditiononZ.ConditionallyonZ
isaGaussianprocesswit
)
Z
(3

wher
=Cov
;
)
Cov(
;
d
q
Var
d
(4andCov
;
)

u

u
sa
(5Weareinterestedincalculatingalowerbound(L
intables1,2and3)andthecorresponding upperbound(U
intables1,2and3).Wedothatbyconsideringthefollowingargument.Therexistssomevariabl

suchthat
))

))]

)
))]

)
0

)
so
))
))

)
0

)
)

))

)


))]

)
su

0
Thus,inthecasewheref(x)

b
,thelowerboundisgivenby L

))](6andthecorrespondingupperboundisgivenby U
=L
E(Var
)
(7sincesu

0
)
.Her

d
.Thus
Var(
Z

d
)]

Z
Z
dudv

Z
d
)
Z
Z
u

1
dudv:
(8Letusdene
)
Z

d
)
Z
u
du
(9Inthecaseofcalculatingthepriceofthebond



d
thelowerboundisgivenbyL
Z

b
p


d
(10andthecorrespondingupperboundisgivenby U
Z

b
p


d
Z
Z
u

1
dvdu:
(11