Numerical and analytical methods for bond pricing in short rate convergence models of interest rates

TL;DR

This paper reviews recent analytical and numerical methods for pricing bonds within short rate convergence models, especially in the context of Euro adoption, focusing on solving PDEs for bond prices.

Contribution

It provides a comprehensive survey of methods for approximating bond prices in short rate models related to Euro convergence, combining analytical and numerical approaches.

Findings

Analytical solutions are limited to special cases.

Numerical methods are essential for general models.

The paper compares different approximation techniques.

Abstract

In this survey paper we discuss recent advances on short interest rate models which can be formulated in terms of a stochastic differential equation for the instantaneous interest rate (also called short rate) or a system of such equations in case the short rate is assumed to depend also on other stochastic factors. Our focus is on convergence models, which explain the evolution of interest rate in connection with the adoption of Euro currency. Here, the domestic short rate depends on a stochastic European short rate. In short rate models, the bond prices, which determine the term structure of interest rate, are obtained as solutions to partial differential equations. Analytical solutions are available only in special cases; therefore we consider the question of obtaining their approximations. We use both analytical and numerical methods to get an approximate solution to the partial differential equation for bond prices.