A novel partial integrodifferential equation-based framework for pricing interest rate derivatives under jump-extended short-rate models

Abstract

Interest rate derivatives under jump-extended short-rate models have commonly been valued using lattice methods. Unfortunately, lattice methods have pitfalls, mainly in terms of accuracy, efficiency and ease of programming. This paper proposes a much faster and more accurate valuation method based on partial integrodifferential equations (PIDEs). Spatial differential and integral terms are discretized by fourthorder finite differences and Simpson's rule, respectively. For the time-stepping, we investigate a Crank-Nicolson scheme, an implicit-explicit (IMEX) scheme and an exponential time integration scheme. We demonstrate our method by pricing bonds as well as European and American options on both zero-coupon and coupon bonds under jump-extended constant-elasticity-of-variance processes. Through a variety of test problems, we demonstrate that our PIDE-based approach is remarkably superior to lattice methods in terms of accuracy, speed and ease of implementation. By way of example, pricing a one-year zero-coupon bond under the Vasicek model extended with exponential jumps, our method attains an accuracy of 104 in 0:09 seconds with the IMEX scheme, whereas a truncated tree takes 78 seconds to reach the same accuracy.