A Bond Option Pricing Formula in the Extended CIR Model, with an Application to Stochastic Volatility

Zheng Liu; Qidi Peng; henry Schellhorn

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arXiv · 1312.3661

A Bond Option Pricing Formula in the Extended CIR Model, with an Application to Stochastic Volatility

Zheng Liu·Qidi Peng·henry Schellhorn

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Abstract

We provide a complete representation of the interest rate in the extended CIR model. Since it was proved in Maghsoodi (1996) that the representation of the CIR process as a sum of squares of independent Ornstein-Uhlenbeck processes is possible only when the dimension of the interest rate process is integer, we use a slightly different representation, valid when the dimension is not integer. Our representation consists in an infinite sum of squares of basic processes. Each basic process can be described as an Ornstein-Uhlenbeck process with jumps at fixed times. In this case, the price of a bond option resembles the Black-Scholes formula, where the normal distribution is replaced by the generalized chi-square distribution. The formula is in closed form, up to the solution of a Riccati equation for the bond price of the option. We then provide a generalization of our representation to an extended CIR model with stochastic volatility. We present a closed form approximation of the price of a bond option, valid when the expiration of the option is small and the speed of mean-reversion of volatility is high. The approximation is in "full" closed form, i.e., it does not require to solve an ordinary differential equation.

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BibTeX RIS

Zheng Liu, Qidi Peng, henry Schellhorn. 2013-12-12. A Bond Option Pricing Formula in the Extended CIR Model, with an Application to Stochastic Volatility. https://arxiv.org/abs/1312.3661

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