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.
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
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