A highly sensitive mean-reverting process in finance and the Euler-Maruyama approximations

Fuke Wu, Xuerong Mao, Kan Chen, Chinese Scholarship Council (Funder)

Research output: Contribution to journalArticle

18 Citations (Scopus)
77 Downloads (Pure)

Abstract

Empirical studies show that the most successful continuous-time models of the short term rate in capturing the dynamics are those that allow the volatility of interestchanges to be highly sensitive to the level of the rate. However, from the mathematics, the high sensitivity to the level implies that the coeffcients do not satisfy the lineargrowth condition, so we can not examine its properties by traditional techniques. This paper overcomes the mathematical difculties due to the nonlinear growth and examines its analytical properties and the convergence of numerical solutions in probability. The convergence result can be used to justify the method within Monte-Carlo simulations that compute the expected payoff of financial products. For illustration, we apply our results compute the value of a bond with interest rate given by the highly sensitive mean-reverting process as well as the value of a single barrier call option with the asset price governed by this process.
Original languageEnglish
Pages (from-to)540-554
Number of pages15
JournalJournal of Mathematical Analysis and Applications
Volume348
Issue number1
DOIs
Publication statusPublished - 1 Dec 2008

    Fingerprint

Keywords

  • structure of interest rate
  • stochastic differential equation
  • convergence in probability
  • Euler-Maruyama method
  • Monte-Carlo simulation

Cite this