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Deriving Closed-Form Solutions for Gaussian Pricing Models: A Systematic Time-Domain Approach

Author

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  • Alexander Levin

    (The Dime Bancorp, Inc., Treasury Department, 589 5th Ave, New York, NY 10017, USA)

Abstract

A systematic time-domain approach is presented to the derivation of closed-form solutions for interest-rate contingent assets. A financial system "asset — interest rate market" is assumed to follow an any-factor system of linear stochastic differential equations and some piece-wise defined algebraic equations for the payoffs. Closed-form solutions are expressed through the first two statistical moments of the state variables that are proven to satisfy a deterministic linear system of ordinary differential equations.A number of examples are given to illustrate the method's effectiveness. With no restrictions on the number of factors, solutions are derived for randomly amortizing loans and deposits; any European-style swaptions, caps, and floors; conversion options; Asian-style options, etc. A two-factor arbitrage-free Gaussian term structure is introduced and analyzed.

Suggested Citation

  • Alexander Levin, 1998. "Deriving Closed-Form Solutions for Gaussian Pricing Models: A Systematic Time-Domain Approach," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 1(03), pages 349-376.
    • Handle: RePEc:wsi:ijtafx:v:01:y:1998:i:03:n:s0219024998000205
    DOI: 10.1142/S0219024998000205
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