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A Technique for Reducing Discretization Bias from Monte Carlo Simulations: Option Pricing under Stochastic Interest Rates

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  • Snorre Lindset
  • Arne-Christian Lund

Abstract

Control variates are often used to reduce variability in Monte Carlo estimates and their effectiveness is traditionally measured by the so-called speed-up factor. The main objective of this paper is to demonstrate that a control variate can also be applied to reduce the bias stemming from the discretization of the state variable dynamics. This is particularly valuable when stochastic interest rate models are discretized, since bias reduction through more grid points is computationally expensive.

Suggested Citation

  • Snorre Lindset & Arne-Christian Lund, 2007. "A Technique for Reducing Discretization Bias from Monte Carlo Simulations: Option Pricing under Stochastic Interest Rates," The European Journal of Finance, Taylor & Francis Journals, vol. 13(6), pages 545-564.
    • Handle: RePEc:taf:eurjfi:v:13:y:2007:i:6:p:545-564
    DOI: 10.1080/13518470701198791
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    References listed on IDEAS

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    1. Robert C. Merton, 2005. "Theory of rational option pricing," World Scientific Book Chapters, in: Sudipto Bhattacharya & George M Constantinides (ed.), Theory Of Valuation, chapter 8, pages 229-288, World Scientific Publishing Co. Pte. Ltd..
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