Scandinavian Working Papers in Business Administration

Finance Working Papers,
University of Aarhus, Aarhus School of Business, Department of Business Studies

No 02-21: Valuation of Path-Dependent Interest Rate Derivatives in a Finite Difference Setup

Mikkel Svenstrup ()
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Mikkel Svenstrup: Department of Finance, Aarhus School of Business, Postal: Fuglesangs Allé 4, 8210 Aarhus V, Denmark

Abstract: In this paper we study and implement a finite difference version of the augmented

state variable approach proposed by Hull & White (1993) that allows for pathdependent

securities. We apply the method to a class of path-dependent interest

rate derivatives and consider several examples including mortgage backed securities

and collateralized mortgage obligations. The efficiency of the method is assessed in

a comparative study with Monte Carlo simulation and we find it to be faster for a

similar accuracy.

Keywords: Path-dependent Options; Finite Difference; Mortgage Backed Securities

20 pages, May 9, 2003

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