Pricing Interest Rate Exotics in Multi-Factor Gaussian Interest Rate Models

Abstract

For many interest rate exotic options, for example options on the slope of the yield curve or American featured options, a one factor assumption for term structure evolution is inappropriate. These options derive their value from changes in the slope or cuvature of the yield curve and hence are more realistically priced with multiple factor models. However, efficient construction of short rate trees becomes computationally intractable as we increase the number of factors and in particular as we move to non-Markovian models. In this paper we describe a general framework for pricing a wide range of interest rate exotic options under a very general family of multi-factor Gaussian interest rate models. Our framework is based on a computationally efficient implementation of Monte Carlo integration utilising analytical approximations as control variates. These techniques extend the analysis of Clewlow, Pang and Strickland [1997] for pricing interest rate caps and swaptions.