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Evaluation of Derivative Security Prices in the Heath-Jarrow-Morton Framework as Path Integrals Using Fast Fourier Transform Techniques

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Abstract

This paper considers the evaluation of derivative security prices within the Heath-Jarrow-Morton framework of stochastic interest rates, such as bond options. Within this framework, the stochastic dynamics driving prices are in general non-Markovian. Hence, in principle the partial differential equations governing prices require an infinite dimensinal state space. We discuss a class of forward rate volatility functions which allow the stochastic dynamics to be expressed in Markovian form and hence obtain a finite dimensional state space for the partial differential equations governing prices. By applying to the Markovian form, the transformed suggested by Eydeland (1994), the pricing problem can be set up as a path integral in function space. These integrals are evaluated using fast fourier transform techniques. We apply the technique to the pricing of American bond options and compare the computational time with other methods currently employed such as the method of lines and more traditional partial differential equation solution techniques.

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  • 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.
    • Handle: RePEc:uts:wpaper:72
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    Cited by:

    1. Andrew Matacz, 2000. "Path dependent option pricing: the path integral partial averaging method," Science & Finance (CFM) working paper archive 500034, Science & Finance, Capital Fund Management.
    2. Carl Chiarella & Nadima El-Hassan & Adam Kucera, 2004. "Evaluation of Point Barrier Options in a Path Integral Framework Using Fourier-Hermite Expansions," Research Paper Series 126, Quantitative Finance Research Centre, University of Technology, Sydney.
    3. Giacomo Bormetti & Sofia Cazzaniga, 2014. "Multiplicative noise, fast convolution and pricing," Quantitative Finance, Taylor & Francis Journals, vol. 14(3), pages 481-494, March.
    4. Carl Chiarella & Nadima El-Hassan, 1999. "Pricing American Interest Rate Options in a Heath-Jarrow-Morton Framework Using Method of Lines," Research Paper Series 12, Quantitative Finance Research Centre, University of Technology, Sydney.
    5. Belal E. Baaquie, 1998. "Quantum Field Theory of Treasury Bonds," Papers cond-mat/9809199, arXiv.org.
    6. Ramaprasad Bhar, 2010. "Stochastic Filtering with Applications in Finance," World Scientific Books, World Scientific Publishing Co. Pte. Ltd., number 7736, August.
    7. Ramaprasad Bhar & Carl Chiarella, 1997. "Interest rate futures: estimation of volatility parameters in an arbitrage-free framework," Applied Mathematical Finance, Taylor & Francis Journals, vol. 4(4), pages 181-199.
    8. Belal E. Baaquie & Marakani Srikant & Mitch Warachka, 2002. "A Quantum Field Theory Term Structure Model Applied to Hedging," Papers cond-mat/0206457, arXiv.org.
    9. Sella Lisa, 2008. "Old and New Spectral Techniques for Economic Time Series," Department of Economics and Statistics Cognetti de Martiis. Working Papers 200809, University of Turin.
    10. Giacomo Bormetti & Sofia Cazzaniga, 2011. "Multiplicative noise, fast convolution, and pricing," Papers 1107.1451, arXiv.org.
    11. Andrew Matacz, 2000. "Path Dependent Option Pricing: the path integral partial averaging method," Papers cond-mat/0005319, arXiv.org.
    12. Belal E. Baaquie & Marakani Srikant & Mitch C. Warachka, 2003. "A Quantum Field Theory Term Structure Model Applied to Hedging," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 6(05), pages 443-467.
    13. Marco Rosa-Clot & Stefano Taddei, 2002. "A Path Integral Approach To Derivative Security Pricing Ii: Numerical Methods," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 5(02), pages 123-146.
    14. DECAMPS, Marc & DE SCHEPPER, Ann & GOOVAERTS, Marc, "undated". "Path integrals as a tool for pricing interest rate contingent claims: The case of reflecting and absorbing boundaries," Working Papers 2003027, University of Antwerp, Faculty of Business and Economics.
    15. Slanina, Frantisek, 2013. "Essentials of Econophysics Modelling," OUP Catalogue, Oxford University Press, number 9780199299683.
    16. Chiarella, Carl & El-Hassan, Nadima & Kucera, Adam, 1999. "Evaluation of American option prices in a path integral framework using Fourier-Hermite series expansions," Journal of Economic Dynamics and Control, Elsevier, vol. 23(9-10), pages 1387-1424, September.

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