Interest Rate Barrier Options
Less expensive than standard options, barrier options have become very popular in recent years as useful hedging instruments for risk management strategies. Thus far valuation approaches have largely focused on equity barrier options, where in certain instances analytical expressions may be available. In this paper we use Monte Carlo procedure to value barrier options based on the Chan, Karolyi, Longstaff and Sanders interest rate process. By performing simulations with and without including the recently suggested Sharp Large Deviations, we show that standard Monte Carlo procedure substantially misprices barrier options.
KeywordsInterest rate options barrier options Monte-Carlo simulation
Unable to display preview. Download preview PDF.
- Andersen, Leif, and Rupert Brotherton-Ratcliffe (1996), “Exact Exotics”, Risk, Vol. 9, pp. 85–89.Google Scholar
- Baldi, Paolo, Lucia Caramellino, and Maria G. Iovino (1998), “Pricing Complex Barrier Options with General Features Using Sharp Large Deviation Estimates”. Monte Carlo and Quasi-Monte Carlo Methods, H. Niederreiter, J. Spanier (Eds.), Springer, pp. 149–162.Google Scholar
- Barone-Adesi, Giovanni, Elias Dinenis and Ghulam Sorwar (1997), “The Convergence of Binomial Approximation for Interest Rate Models”, Journal of Financial Engineering, Vol. 6, pp. 71–78.Google Scholar
- Beaglehole, David, R, Phillip H. Dybvig and Guofu Zhou (1997), “Going to Extremes: Correcting Simulation Bias in Exotic Option Valuation. ”Financial Analyst Journal, Vol. 53, pp. 62–68.Google Scholar
- Gao, Bin (1997), “Convergence Rate of Option Prices from Discrete to Continuous-Time”, University of North Carolina, Working Paper.Google Scholar
- Kloeden, P.E., and E. Platen (1999), Numerical Solutions of Stochastic Differential Equations, New York, Springer-Verlag.Google Scholar
- Rubinstein, Mark, and Eric S. Reiner (1991), “Breaking Down the Barriers” Risk, Vol. 4, No. 8, pp. 28–35.Google Scholar