Interest Rate Derivatives:
Model of the Short Rate
Chapter 30
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Term Structure Models
Black’s model is concerned with
describing the probability distribution of a
single variable at a single point in time
A term structure model describes the
evolution of the whole yield curve
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The Zero Curve
The process for the instantaneous short rate, r, in the traditional
risk-neutral world defines the process for the whole zero curve in
this world
If P(t, T ) is the price at time t of a zero-coupon bond maturing at
time T
where is the average r between times t and T
P(t , T ) E e
r (T t )
r
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Equilibrium Models
Rendleman & Bartter:
dr r dt r dz
Vasicek:
dr a ( b r ) dt dz
Cox, Ingersoll, & Ross (CIR):
dr a ( b r ) dt r dz
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Mean Reversion
(Figure 30.1, page 683)
Interest
rate
HIGH interest rate has negative trend
Reversion
Level
LOW interest rate has positive trend
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Alternative Term Structures
in Vasicek & CIR
(Figure 30.2, page 684)
Zero Rate Zero Rate
Maturity Maturity
Zero Rate
Maturity
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Equilibrium vs No-Arbitrage
Models
In an equilibrium model today’s
term structure is an output
In a no-arbitrage model today’s
term structure is an input
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Developing No-Arbitrage
Model for r
A model for r can be made to fit the
initial term structure by including a
function of time in the drift
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Ho-Lee Model
dr = (t)dt + dz
Many analytic results for bond prices and
option prices
Interest rates normally distributed
One volatility parameter,
All forward rates have the same standard
deviation
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Diagrammatic Representation of
Ho-Lee (Figure 30.3, page 687)
Short r
Rate
r
r
r
Time
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Hull-White Model
dr = [(t ) – ar ]dt + dz
Many analytic results for bond prices and
option prices
Two volatility parameters, a and
Interest rates normally distributed
Standard deviation of a forward rate is a
declining function of its maturity
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Diagrammatic Representation of Hull
and White (Figure 30.4, page 688)
r
Short
Rate
r Forward Rate
Curve
r
r
Time
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Black-Karasinski Model (equation
30.18)
d ln(r ) (t ) a (t ) ln(r ) dt (t ) dz
Future value of r is lognormal
Very little analytic tractability
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Options on Zero-Coupon Bonds
(equation 30.20, page 690)
In Vasicek and Hull-White model, price of call maturing at T
on a bond lasting to s is
LP(0,s)N(h)-KP(0,T)N(h-P)
Price of put is
KP(0,T)N(-h+P)-LP(0,s)N(h)
where
LP (0, s ) P 1 e 2 aT
1
h ln
P P(0, T ) K 2
P 1 e
a
a(s T )
2a
L is the principal and K is the strike price.
For Ho - Lee σ P ( s T ) T
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Options on Coupon Bearing
Bonds
Ina one-factor model a European option on a
coupon-bearing bond can be expressed as a
portfolio of options on zero-coupon bonds.
We first calculate the critical interest rate at
the option maturity for which the coupon-
bearing bond price equals the strike price at
maturity
The strike price for each zero-coupon bond is
set equal to its value when the interest rate
equals this critical value
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Interest Rate Trees vs Stock
Price Trees
The variable at each node in an interest
rate tree is the t-period rate
Interest rate trees work similarly to stock
price trees except that the discount rate
used varies from node to node
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Two-Step Tree Example
(Figure 30.6, page 692)
Payoff after 2 years is MAX[100(r – 0.11), 0]
pu=0.25; pm=0.5; pd=0.25; Time step=1yr
14%
3
12%
1.11* 12%
1
10% 10% 10%
0.35** 0.23 0
8%
8% 0
0.00
6%
0
*: (0.25×3 + 0.50×1 + 0.25×0)e–0.12×1
**: (0.25×1.11 + 0.50×0.23 +0.25×0)e–0.10×1
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Alternative Branching Processes
in a Trinomial Tree
(Figure 30.7, page 693)
(a) (b) (c)
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Procedure for Building Tree
dr = [(t ) – ar ]dt + dz
1. Assume (t ) = 0 and r (0) = 0
2. Draw a trinomial tree for r to match
the mean and standard deviation of the
process for r
3. Determine (t ) one step at a time so
that the tree matches the initial term
structure
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Example (page 694 to 699)
= 0.01
a = 0.1
t = 1 year
The zero curve is as shown in
Table 30.1 on page 697
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Building the First Tree for the t
rate R
Set vertical spacing:
R 3t
Change branching when jmax nodes from
middle where jmax is smallest integer greater
than 0.184/(at)
Choose probabilities on branches so that
mean change in R is -aRt and S.D. of
change is t
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The First Tree
(Figure 30.8, page 695)
E
B F
C G
A
D H
Node A B C D E F G H I
R 0.000% 1.732% 0.000% -1.732% 3.464% 1.732% 0.000% -1.732% -3.464%
pu 0.1667 0.1217 0.1667 0.2217 0.8867 0.1217 0.1667 0.2217 0.0867
pm 0.6666 0.6566 0.6666 0.6566 0.0266 0.6566 0.6666 0.6566 0.0266
pd 0.1667 0.2217 0.1667 0.1217 0.0867 0.2217 0.1667 0.1217 0.8867
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Shifting Nodes
Work forward through tree
Remember Qij the value of a derivative
providing a $1 payoff at node j at time it
Shift nodes at time it by i so that the
(i+1)t bond is correctly priced
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The Final Tree
(Figure 30.9, Page 697)
E
F
B
G
C
H
A
D
I
Node A B C D E F G H I
R 3.824% 6.937% 5.205% 3.473% 9.716% 7.984% 6.252% 4.520% 2.788%
pu 0.1667 0.1217 0.1667 0.2217 0.8867 0.1217 0.1667 0.2217 0.0867
pm 0.6666 0.6566 0.6666 0.6566 0.0266 0.6566 0.6666 0.6566 0.0266
pd 0.1667 0.2217 0.1667 0.1217 0.0867 0.2217 0.1667 0.1217 0.8867
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Extensions
The tree building procedure can be extended
to cover more general models of the form:
dƒ(r ) = [(t ) – a ƒ(r )]dt + dz
We set x=f(r) and proceed similarly to before
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Calibration to determine a
and
The volatility parameters a and (perhaps
functions of time) are chosen so that the model fits
the prices of actively traded instruments such as
caps and European swap options as closely as
possible
We minimize a function of the form
n
i i P
(
i 1
U V ) 2
where Ui is the market price of the ith calibrating
instrument, Vi is the model price of the ith
calibrating instrument and P is a function that
penalizes big changes or curvature in a and
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