Valuation of Common Two-Factor Interest Rate Contingent Claims

Abstract

Numerous two-factor interest rate models have been proposed that have attempted to overcome the limitations of one-factor interest rate models. These two-factor interest rate models lead to complex valuation equations for interest rate contingent claims. These valuation equations can be expressed in the form of partial differential equations that can only be solved numerically. Sorwar and Barone-Adesi (2002) have recently extended the Box Method to solve second order partial differential equations. They find that the Box Method outperforms the existing finite difference scheme. In this paper we use their approach to value interest rate contingent claims based on a wide range of two-factor interest rate models. Our approach is to treat the first factor as the short term interest rate and the second factor as the long term interest rate. In this paper we use the Markov Chain Monte Carlo approach to estimate parameters based on two-factor, Vasicek, CIR and CKLS models. We find wide variation in parameter values across different models. We also find that these parameters have a major impact on contingent claim values. In particular we find a wide variation in contingent claim price across different models.