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Valuing Derivative Securities Using the Explicit Finite Difference Method

Published online by Cambridge University Press:  06 April 2009

Abstract

This paper suggests a modification to the explicit finite difference method for valuing derivative securities. The modification ensures that, as smaller time intervals are considered, the calculated values of the derivative security converge to the solution of the underlying differential equation. It can be used to value any derivative security dependent on a single state variable and can be extended to deal with many derivative security pricing problems where there are several state variables. The paper illustrates the approach by using it to value bonds and bond options under two different interest rate processes.

Type
Research Article
Copyright
Copyright © School of Business Administration, University of Washington 1990

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