May 2, 2003

Rolf Poulsen
AMS, IMF, KU
rolf@math.ku.dk

Working with the Cox-Ingersoll-Ross Model

In this project we take a closer look at the Cox-Ingersoll-Ross (CIR) model
given by the stochastic differential equation (SDE)
p
dr(t) = ( r(t))dt + r(t)dW (t).
Modelling the short rate by such a process was suggested in Cox, Ingersoll &
Ross (1985b). This was done to illustrate the workings of a general equilibrium
model suggested by the same authors in Cox, Ingersoll & Ross (1985a). The
general equilibrium model draws heavily on stochastic optimal control theory.
Therefore the questions do not refer directly to the original articles.

Moments
Show that
E(r(t)) = r(0)et + (1 et ) = m(r(0); t).

Hint: Write the SDE on integral form, take mean & observe that what you
have is just a linear ordinary differential equation (ODE). See example 3.13 in
Bjork (1998).
Show that
Var(r(t)) = r(0)

2 t
2
(e e2t ) + (1 et )2 := v(r(0), t).

Hint: Use the same technique as above on r(t)2 . Use the solution too. Arrive
at an ODE for the variance.
Compare (numbers, graphs) the (true) moments to the Euler-type approximations
E(r(t)) r(0) + t( r(0)) and Var(r(t)) t 2 r(0).
The (extremely) energetic student continues this processes to find 3., 4. etc.
order moments.
Because r is a time-homogeneous Markov process conditional moments are
given by m(r(s), t s) and v(r(s), t s).

Estimation
1

Suppose we have equidistant observations ( apart) observations r0 , r1 , . . . , rn ,

where we write ri simply as ri .
The transition densities in the CIR model are not Gaussian. But if we have
time-points (say s and t) that are not too far apart it is natural to approximate
the distribution of r(t) by a normal distribution with mean m(r(s), t s) and
variance v(r(s), t s).
It is then tempting to use the Gaussian (log)likelihood function
ln () =

n
X
i=1

ln (ri ; m(ri1 , | ), v(ri1 , | ),

where (y; m, v) = exp((y m)2 /(2v))/ 2v denotes the mean-m, variancev normal density, and the dependence on the unknown parameter, = (, , ),
has been made notationally explicit.
Write a program that calculates this function (given data and parameters).
When we say use the likelihood we mean use as estimator the parametervalue that maximizes it. Get hold of some data. These can either be real
life interest rates or simulated data from the CIR process. For this you may
need to look in Chapter 3 in Seydel (2002); be sure to make the schemediscretization-stepsize considerably smaller than the time between observations. Plug these into the Gaussian likelihood function. Estimate by maximizing numerically. In R this can be done with the command optimize.

Consistency & the Gaussian Approximation

One could be worried that the Gaussian approximation is bad (when is
small?) and the estimators are inconsistent. The last not true. Irrespective
of the value of , the estimator is consistent (ie. it converges to the true
parameter when the no. observations grows). You can take an important
step in proving this by showing that the Gaussian likelihood function is a
martingale, i.e.
En (ln+1 ()) = ln ().
This ensures consistency; see Bibby & Srensen (1995) for instance.
The difference between the true CIR-density and the Gaussian density can be
investigated by noting that transition densities solve parabolic partial differential equations (PDEs); see the so-called Kolmogorov equations in Propositions
4.10 and 4.12 in Bjork (1998). These are the kind of PDEs that we have grown
accustomed to solving in this course (Project 2, more specifically). Solve numerically for the CIR-density & compare. There are details in Section 3.2 of
Poulsen (1999).

Specification Test; CIR vs. Vasicek

Let F (; x) denote the distribution function of r given r0 = x. Put ui =
F (ri ; ri1 ). These are called generalized residuals. Show that ui s are uniformly distributed on [0, 1] and independent. This can be used to create
goodness-of-fit-tests. Get hold of some data. Estimate the CIR model. Estimate the Vasicek model. Calculate generalized residuals for the two models.
(Use the approximate Gaussian likelihood function; plug in estimates instead
of unknown true parameters whenever you need to). Compare residuals to
U (0; 1)-variables. (Moments, autocorrelation, Q/Q-plots, maybe youve heard
of Kolmogorov/Smirnov tests, . . .)
The approach above is one way to compare CIR to Vasicek. But we would like
a more direct way, ie. a general model that has as different special cases the
CIR and Vasicek model. Such a model is given by the so-called CKLS (after
Chan, Karolyi, Longstaff & Sanders (1992)) specification:
dr(t) = ( r(t))dt + r(t) dW (t),
where the unknown parameter is now = (, , , ). Unfortunately, transition densities or moments are not known for general , so consistent inference
is difficult. But to get the show on the road we can use the Euler-type moment
approximations
E(r(t))) r(0) + t( r(0)) and Var(r(t)) t 2 r(0)2
in conjunction with the Gaussian likelihood. Try to estimate the CKLSspecification on some real data. What is the -estimate?

(Small Sample) Behaviour of Estimators

Simulate CIR data; say n observations apart. Find estimators. Repeat
M times (for instance 100 or 500). How do estimators behave? Are they
unbiased? Try different ns and s.

The Bond Price Formula

Verify the ZCB price formula for the CIR model given in Proposition 17.6
in Bjork (1998) (and on page 58 in the Brigo & Mercurio hand-out.) What
assumption is made about risk-premia?
The verification can be done by brute force by differentiating and seeing
that the A and B functions solve their respective ODEs (Proposition 17.2 in
Bjork (1998)). However, the calculations get very messy. But afterward you
can walk around the finance community with a smug expression on your face.
A more constructive hint is the following:
The ODE for B reads
dB
= aB 2 bB 1 = (B c1 )(B c2 )
dt
3

for some appropriate constants (its your job to find them). This ODE is of a
form you can use separation of variables on. Consult the differential equation
section of your 1. year math-book. The message is that you have to look at
Z
Z
dB
+ c = dt,
(B c1 )(B c2 )
where you forget that B is a function in the LHS integral. Any table will
tell you that the LHS integral is
ln(B c2 ) ln(B c1 )
+
.
c2 c 1
c1 c 2
The RHS is just t. Determine the constant of integration, c, and solve for B
in terms of t.

References
Bibby, B. M. & Srensen, M. (1995), Martingale estimating functions for
discretely observed diffusion processes, Bernoulli 1, 1739.
Bjork, T. (1998), Arbitrage Theory in Continuous Time, Oxford.
Chan, K. C., Karolyi, G. A., Longstaff, F. A. & Sanders, A. B. (1992), An
Empirical Comparison of Alternative Models of the Short-Term Interest
rate, Journal of Finance 47, 12091227.
Cox, J. C., Ingersoll, J. E. & Ross, S. A. (1985a), A Theory of the Term
Structure of Interest Rates, Econometrica 53, 385407.
Cox, J. C., Ingersoll, J. E. & Ross, S. A. (1985b), An intertemporal general
equilibrium model of asset prices, Econometrica 53, 363384.
Poulsen, R. (1999), Approximate Maximum Likelihood Estimation of Discretely Observed Diffusion Processes. Working paper no. 29, Centre for
Analytical Finance, University of Aarhus.
Seydel, R. (2002), Tools for Computational Finance, Springer.