An Optimal Selection of the basis Functions for the Valuation of Interest Rate Structured Notes

Hanki Seong (Hanyang University)
Sang Bin Lee (Hanyang University)

Journal of Derivatives and Quantitative Studies: 선물연구

ISSN: 1229-988X

Article publication date: 30 November 2014

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Abstract

This paper examines which basis functions are efficient to employ a combined method of Hull and White (1990) with the Monte Carlo simulation when we price a callable range note or a callable bond. We use the Huge and Rom-Poulsen (2007) method which has modified the least squared Monte Carlo simulation proposed by Longstaff and Schwartz (2001) to reduce the estimation errors of the continuation value or the underlying assets. To use Monte carlo Simulation for pricing the early exercise premium, it is essential to accurately estimate the continuation value, because the investors will choose the higher value between the exercise and the continuation value at the possible early exercise dates. The main purpose of this paper is to analyze the estimation errors originating from the choice of the basis functions for the underlying asset and the continuation value estimation.

We choose the callable bond and the callable range accrual note to show which basis functions are reliable to reduce the estimation errors. For this purpose, we replicate the callable range accrual note with a portfolio of a fixed rate bond and a delayed digital option. We use several basis functions such as a constant, the instantaneous interest rates, and the range in order to see which basis function is efficient for our purpose. We examine several combinations of the basis functions depending on which basis functions will be used for the underlying asset or the continuation value estimation. We show that the range which is an important determinant of the callable range accrual note is an effective basis function to accurately determine the underlying asset and the continuation value for the pricing of the callable range accrual note.

Keywords

Citation

Seong, H. and Lee, S.B. (2014), "An Optimal Selection of the basis Functions for the Valuation of Interest Rate Structured Notes", Journal of Derivatives and Quantitative Studies: 선물연구, Vol. 22 No. 4, pp. 637-674. https://doi.org/10.1108/JDQS-04-2014-B0003

Publisher

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Emerald Publishing Limited

Copyright © 2014 Emerald Publishing Limited

License

This article is published under the Creative Commons Attribution (CC BY 4.0) licence. Anyone may reproduce, distribute, translate and create derivative works of this article (for both commercial and non-commercial purposes), subject to full attribution to the original publication and authors. The full terms of this licence may be seen at http://creativecommons.org/licences/by/4.0/legalcode


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