P1:Naresh August27,2007 11:34 C925X C925X˙C000 P1:Naresh August27,2007 11:34 C925X C925X˙C000 P1:Naresh August27,2007 11:34 C925X C925X˙C000 P1:Naresh August27,2007 11:34 C925X C925X˙C000 Chapman & Hall/CRC Taylor & Francis Group 6000 Broken Sound Parkway NW, Suite 300 Boca Raton, FL 33487-2742 © 2008 by Taylor & Francis Group, LLC Chapman & Hall/CRC is an imprint of Taylor & Francis Group, an Informa business No claim to original U.S. Government works Printed in the United States of America on acid-free paper 10 9 8 7 6 5 4 3 2 1 International Standard Book Number-13: 978-1-58488-925-0 (Hardcover) This book contains information obtained from authentic and highly regarded sources. Reprinted material is quoted with permission, and sources are indicated. A wide variety of references are listed. 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Trademark Notice: Product or corporate names may be trademarks or registered trademarks, and are used only for identification and explanation without intent to infringe. Library of Congress Cataloging-in-Publication Data Miller, John (John James Henry), 1937- Numerical methods for finance / John Miller and David Edelman. p. cm. -- (Financial mathematics series) Papers presented at a conference. Includes bibliographical references and index. ISBN-13: 978-1-58488-925-0 (alk. paper) ISBN-10: 1-58488-925-X (alk. paper) 1. Finance--Mathematical models--Congresses. I. Edelman, David. II. Title. III. Series. HG106.M55 2007 332.01’5195--dc22 2007014372 Visit the Taylor & Francis Web site at http://www.taylorandfrancis.com and the CRC Press Web site at http://www.crcpress.com P1:Naresh August27,2007 11:34 C925X C925X˙C000 Contents Preface......................................................vii ListofContributors...........................................ix AbouttheEditors............................................xiii Sponsors.....................................................xv CHAPTER 1 (cid:2) CoherentMeasuresofRiskintoEveryday MarketPractice.................................1 CarloAcerbi CHAPTER 2 (cid:2) PricingHigh-DimensionalAmericanOptions UsingLocalConsistencyConditions.............13 S.J.BerridgeandJ.M.Schumacher CHAPTER 3 (cid:2) AdverseInterriskDiversificationEffects forFXForwards...............................53 ThomasBreuerandMartinJandaˇcka CHAPTER 4 (cid:2) CounterpartyRiskPricingunderCorrelation betweenDefaultandInterestRates...............63 DamianoBrigoandAndreaPallavicini CHAPTER 5 (cid:2) OptimalDynamicAssetAllocationfor DefinedContributionPensionPlans.............83 AndrewJ.G.Cairns,DavidBlake,andKevinDowd CHAPTER 6 (cid:2) OnHigh-PerformanceSoftwareDevelopment fortheNumericalSimulationofLife InsurancePolicies..............................87 S.Corsaro,P.L.DeAngelis,Z.Marino,andF.Perla CHAPTER 7 (cid:2) AnEfficientNumericalMethodforPricing InterestRateSwaptions........................113 MarkCumminsandBernardMurphy v P1:Naresh August27,2007 11:34 C925X C925X˙C000 vi (cid:2) CONTENTS CHAPTER 8 (cid:2) EmpiricalTestingofLocalCrossEntropyasa MethodforRecoveringAsset’sRisk-Neutral PDFfromOptionPrices.......................149 Vladim´ırDobia´ˇs CHAPTER 9 (cid:2) UsingIntradayDatatoForecastDaily Volatility:AHybridApproach..................173 DavidC.EdelmanandFrancescoSandrini CHAPTER10 (cid:2) PricingCreditfromtheTopDownwith AffinePointProcesses.........................195 EymenErrais,KayGiesecke,andLisaR.Goldberg CHAPTER11 (cid:2) ValuationofPerformance-DependentOptions inaBlack–ScholesFramework ................. 203 ThomasGerstner,MarkusHoltz,andRalfKorn CHAPTER12 (cid:2) VarianceReductionthroughMultilevel MonteCarloPathCalculations.................215 MichaelB.Giles CHAPTER13 (cid:2) ValueatRiskandSelf-Similarity................225 OlafMenkens CHAPTER14 (cid:2) ParameterUncertaintyinKalman-Filter EstimationoftheCIRTerm-StructureModel....255 ConallO’Sullivan CHAPTER15 (cid:2) EDDIEforDiscoveringArbitrage Opportunities................................281 EdwardTsang,SheriMarkose,AlmaGarcia,andHakanEr Index ...................................................... 285 P1:Naresh August27,2007 11:34 C925X C925X˙C000 Preface This volume contains a refereed selection of papers, which were first presented at the international conference on Numerical Methods for FinanceheldinDublin,IrelandinJune2006andwerethensubmitted forpublication.Therefereeingprocedurewascarriedoutbymembers of the International Steering Committee, the Local Organizing Com- mitteeandtheEditors. The aim of the conference was to attract leading researchers, both practitioners and academics, to discuss new and relevant numerical methodsforthesolutionofpracticalproblemsinfinance. The conference was held under the auspices of the Institute for Numerical Computation and Analysis, a non-profit company limited byguarantee;seehttp://www.incaireland.orgformoredetails. It is a pleasure for us to thank the members of the International SteeringCommittee: ElieAyache(ITO33,Paris,France) PhelimBoyle(UniversityofWaterloo,Ontario,Canada) RamaCont(EcolePolytechnique,Palaiseau,France) PaulGlasserman(ColumbiaUniversity,NewYork,USA) SamHowison(UniversityofOxford,UK) JohnJ.H.Miller(INCA,Dublin,Ireland) HaraldNiederreiter(NationalUniversityofSingapore) EckhardPlaten(UniversityofTechnologySydney,Australia) WilSchilders(Philips,Eindhoven,Netherlands) HansSchumacher(TilburgUniversity,Netherlands) RuedigerSeydel(UniversityofCologne,Germany) TonVorst(ABN-AMRO,Amsterdam,Netherlands) PaulWilmott(WilmottAssociates,London,UK) LixinWu(UniversityofScience&Technology,HongKong,China) andthemembersoftheLocalOrganizingCommittee: JohnA.D.Appleby(DublinCityUniversity) NikolaiDokuchaev(UniversityofLimerick) vii P1:Naresh August27,2007 11:34 C925X C925X˙C000 viii (cid:2) PREFACE DavidC.Edelman(SmurfitBusinessSchool,Dublin) PeterGorman(CharteredAccountant,Dublin) BernardHanzon(UniversityCollegeCork) FrankMonks(NexgenCapital,Dublin) FrankOertel(UniversityCollegeCork) ShaneWhelan(UniversityCollegeDublin) Inaddition,wewishtothankoursponsors,withouttheirenthusiasm andpracticalhelp,thisconferencewouldnothavesucceeded. TheEditors JohnA.D.Appleby DavidC.Edelman JohnJ.H.Miller Dublin,Ireland P1:Naresh August27,2007 11:34 C925X C925X˙C000 List of Contributors CarloAcerbi DamianoBrigo Abaxbank CreditModels-BancaIMICorso CorsoMonforte34,20122Milano Matteotti6 20121Milano,Italy P.L.DeAngelis UniversityofNaplesParthenope AndrewJ.G.Cairns ViaMedina MaxwellInstitute 40-80133Naples,Italy Edinburgh S.J.Berridge ActuarialMathematics ManInvestments andStatistics SugarQuay, Heriot-WattUniversity LowerThamesSt Edinburgh,EH144AS, LondonEC3R6DU UnitedKingdom DavidBlake S.Corsaro PensionsInstitute UniversityofNaplesParthenope CassBusinessSchool ViaMedina CityUniversity 40-80133Naples,Italy 106BunhillRow,London,EC1Y 8TZ,UnitedKingdom. KevinDowdCentreforRisk& MarkCummins InsuranceStudies Dept.Accounting&Finance NottinghamUniversityBusiness KemmyBusinessSchool School UniversityofLimerick JubileeCampus,Nottingham,NG8 StefaniaCorsaro 1BB,UnitedKingdom UniversityofNaplesParthenope ThomasBreuer ViaMedina PPEResearchCentre 40-80133Naples,Italy FHVorarlberg, Hochschulstrasse1,A-6850 Vladim´ırDobia´sˇ Dornbirn UniversityCollegeDublin ix