Simulation in the Real World
17 Pages Posted: 31 Aug 2016
Date Written: August 30, 2016
In this paper, we propose two practicable approaches for consistently modelling the realworld and risk-neutral measures within cross-asset Monte-Carlo frameworks. We go on to explore the necessity of supporting the real-world measure and consider its calibration with the aid of an explicit example of a 3-factor Hull-White model exhibiting the volatility hump and roll-down effect. This example parallels the 1-factor lattice model considered in Hull, Sokol and White, however, allows risk-premia which are stable through time and illustrates the necessity of having a sufficiently rich correlation structure in order to produce realistic dynamic risk-premia.
Keywords: Asset Pricing, Risk Management, Risk-Neutral Pricing, Term Structure of Interest Rates, Esscher Transform
JEL Classification: C02, C15, C51, C58, C63, G12, G13
Suggested Citation: Suggested Citation