Evaluating callable and putable bonds: an eigenfunction expansion approach

DOI10.1016/J.JEDC.2012.06.002MaRDI QIDQ318869zbMATH OpenOpenAlexFDO

Authors Dongjae Lim, Lingfei Li, Vadim Linetsky

Publication date 6 October 2016

Published in Journal of Economic Dynamics and Control (Search for Journal in Brave)

Full work available at URL https://arxiv.org/abs/1206.5046

zbMATH Keywords

option pricinginterest rate modelsoptimal stoppingstochastic gameseigenfunction expansionscallable bondsoptions embedded in bondsstochastic time changes

Mathematics Subject Classification ID

Derivative securities (option pricing, hedging, etc.) (91G20) Applications of game theory (91A80) Stochastic games, stochastic differential games (91A15)

Abstract: We propose an efficient method to evaluate callable and putable bonds under a wide class of interest rate models, including the popular short rate diffusion models, as well as their time changed versions with jumps. The method is based on the eigenfunction expansion of the pricing operator. Given the set of call and put dates, the callable and putable bond pricing function is the value function of a stochastic game with stopping times. Under some technical conditions, it is shown to have an eigenfunction expansion in eigenfunctions of the pricing operator with the expansion coefficients determined through a backward recursion. For popular short rate diffusion models, such as CIR, Vasicek, 3/2, the method is orders of magnitude faster than the alternative approaches in the literature. In contrast to the alternative approaches in the literature that have so far been limited to diffusions, the method is equally applicable to short rate jump-diffusion and pure jump models constructed from diffusion models by Bochner's subordination with a L'{e}vy subordinator.

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