Cocozza, Rosa and De Simone, Antonio
(2011):
*One numerical procedure for two risk factors modeling.*

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## Abstract

We propose a numerical procedure for the pricing of financial contracts whose contingent claims are exposed to two sources of risk: the stock price and the short interest rate. More precisely, in our pricing framework we assume that the stock price dynamics is described by the Cox, Ross Rubinstein (CRR, 1979) binomial model under a stochastic risk free rate, whose dynamics evolves over time accordingly to the Black, Derman and Toy (BDT, 1990) one-factor model. To this aim, we set the hypothesis that the instantaneous correlation between the trajectories of the future stock price (conditional on the current value of the short rate) and of the future short rate is zero. We then apply the resulting stock price dynamics to evaluate the price of a simple contract, i.e. of a stock option. Finally, we compare the derived price to the price of the same option under different pricing models, as the traditional Black and Scholes (1973) model. We expect that, the difference in the two prices is not sensibly large. We conclude showing in which cases it should be helpful to adopt the described model for pricing purposes.

Item Type: | MPRA Paper |
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Original Title: | One numerical procedure for two risk factors modeling |

Language: | English |

Keywords: | option pricing; stochastic short rate model; binomial tree |

Subjects: | G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing ; Trading Volume ; Bond Interest Rates C - Mathematical and Quantitative Methods > C6 - Mathematical Methods ; Programming Models ; Mathematical and Simulation Modeling > C63 - Computational Techniques ; Simulation Modeling C - Mathematical and Quantitative Methods > C6 - Mathematical Methods ; Programming Models ; Mathematical and Simulation Modeling > C65 - Miscellaneous Mathematical Tools G - Financial Economics > G1 - General Financial Markets > G13 - Contingent Pricing ; Futures Pricing |

Item ID: | 30859 |

Depositing User: | Rosa Cocozza |

Date Deposited: | 13 May 2011 11:32 |

Last Modified: | 10 Oct 2019 08:08 |

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URI: | https://mpra.ub.uni-muenchen.de/id/eprint/30859 |