Pricing interest-rate derivatives. A Fourier-transform based approach. (Q2473573)

The book is based on author's Ph.D. Thesis entitled ``Pricing Interest -- Rate Derivatives with Fourier Transform Techniques''. The main objective of this research work was to derive an efficient and accurate pricing tool for interest rate derivatives within a Fourier transform pricing approach, which is generally applicable to exponential-affine jump-diffusion models. The work is based on a technique introduced by Lewis for equity options, the payoff and the stochastic dynamics of interest rate derivatives are transformed separately. Using Fourier Transform methods he develops a modular framework for the pricing of interest-rate derivatives within the class of exponential-affine jump-diffusions. This not only simplifies the application of the residue calculus but also improves the efficiency of numerical evaluation schemes considerably. A refined Fractional Inverse Fast Fourier Transformation algorithm is introduced, which is able to calculate thousands of prices within seconds for a given strike range. The potential of this method is demonstrated for several one- and two-dimensional models. The total work in this monograph is spread over in eleven chapters. The motivation and objectives are discussed in first chapter. The author starts in chapter two with the formulation of a general term structure model, which is, govern by a multivariate jump-diffusion process. Using the concepts of stochastic calculus it is demonstrated how the relevant risk-neutral coefficients of the instantaneous interest-rate process could be obtained. The technique of Fourier Transformation and its inverse have been discussed and the system differential equations of characteristic functions have been solved. In chapter three the author discusses a representative collection of some interest-rte derivative contracts, which can be solved with in the Fourier, based pricing mechanism. It is distinguished between contracts with conditional and unconditional exercise rights, because of the different pricing procedures. Three Fourier based pricing approaches are discussed in detail in fourth chapter. The author describes Heston transform approach of the pricing technique using Fourier transformed Arrow-Debreu state prices, which was further, investigated by Bakshi and Madan. Secondly, the pricing procedure introduced by Carr and Madan has been discussed. The author exploits the Fourier Transformation applied not only to the state price densities but to the entire option price. A valuation approach is introduced where theoretical option prices can be subsequently recovered applying a highly efficient algorithm, namely the Fast Fourier Transform (FFT). Finally the valuation methodology introduced by Lewis has been summarized which has highly modularized composition. Also employing Cauchy's residue theorem, the approach can be considerably used both for interest rate derivatives with unconditional and conditional exercise rights. This Methodology enables the application of an refined IFFT algorithm for implementation of the pricing procedure. The particular Fourier Transformations of payoff functions needed in pricing the contract forms previous presented have been derived in chapter Five. Also it has been derived in case of a one-factor term-structure model the Fourier representation of a swaption and a coupon-bond option, respectively. Chapter six gives an outline of the numerical algorithm used for pricing purposes. It is also distinguished between the computation of derivatives with conditional and unconditional exercise rights. A further refinement of the pricing algorithm for option contracts is presented by application of the Fractional Fourier transformation. The chapter is concluded by the discussion of the issue of finding the optimal parameter constellation of the numerical algorithm. In chapter Seven the author presents jump-diffusion interest-rate models. Both diffusion and jump components are included in order to model be more realistic term-structure models. The jump sizes considered are governed either by Exponential, Normal or Gamma distributions. In order to implement the pricing procedure, the payoff transformations and the particular characteristic functions are required. In chapter eight and nine both jump-enhanced one-factor and two-factor interest-rate models are considered and focus on the impact of different jumps. Chapter ten is devoted to give a perspective of model extensions for which the pricing procedure is also capable in deriving numerical solutions. The first extension is to consider a special model class of non-affine interest-rate models. Another extension of the interest-rate model is to consider stochastic jump intensities. However, due to the non-existence of closed form solutions in any case, these extensions are discussed in brief. In the last chapter the author reviews his results of his study and gives the concluding remarks and suggestions for further research work. The book provides a sophisticated alternative to time-consuming Monte-Carlo simulations, which have to be applied otherwise due to the complicated jump-diffusion dynamics. Combined with the highly efficient FRFT algorithm, this numerical pricing approach offers an accuracy and efficiency, which can be hardly achieved by other methods. Although In the book one- and two- factor interest rate models have been investigated which can easily extend the pricing framework to include also jump-enhanced version of higher models, such as e.g. the multi-factor models. Another possibility for further research might be an empirical validation of the family of Gamma Jump-enhanced diffusion models. In this way the book is very useful for the research workers also in field of the pricing interest rate derivatives.The book is concluded with an exhaustive bibliography on the topic.