Short-Rate and Forward-Rate Models

Lecture 9
Short-rate and forward-rate

models
Jan Palczewski, Continuous Time Finance: MATH 5330M, University of Leeds, 2016/17 p. 1
Zero-coupon bond
A zero-coupon bond is a financial instrument which pays 1 at its maturity T .
Its price at t < T is denoted by
P (t, T ).
Price of a zero-coupon bond provides a unique description of changes of the

value of money over time.
All simple investment instruments, such as saving bonds, loans, etc., can be
represented as appropriate portfolios of zero-coupon bonds.
Relations between rates/bonds
Prices of zero-coupon bonds are usually given in terms of interest rates:
1 1 (T t)R(t,T )
P (t, T ) = = T t = e ,
1 + L(t, T )(T t) 1 + Y (t, T )
where
L(t, T ) is the LIBOR rate (simple compounding)
Y (t, T ) is a yearly compounded rate
R(t, T ) is a continuously compounded rate (used commonly in models).
t time of quotation
T maturity (T t)
FRA
Forward rate agreement (FRA) is an agreement that a certain interest rate
RF will apply to either borrowing or lending of a certain principal during a
specified period of time.
Rate RF is chosen in such a way that the contract is worth 0 when

signed.
Both parties have an obligation to borrow/lend at the rate RF .
The rate RF determined at t (t T1 ) equals

1 P (t, T1 )
RF := F (t, T1 , T2 ) = 1 .
T2 T1 P (t, T2 )
Interest rate derivatives
A caplet is designed to provide an insurance against the rise of the interest
rate above a certain level. A floorlet is designed to provide an insurance
against the fall of the interest rate below a certain level.
T1 - beginning of the period, T2 - end of the period
RK - interest rate (strike price), N - the principal
The payoff of the caplet is paid at T2 and equals

+
N (T2 T1 ) L(T1 , T2 ) RK .
The payoff of the floorlet is paid at T2 and equals

+
N (T2 T1 ) RK L(T1 , T2 ) .
Black76 model
Assumptions: under the risk-neutral measure Q

log L(T1 , T2 ) is normally distributed,
the variance of log L(T1 , T2 ) equals 2 T1 ,

the expectation of L(T1 , T2 ) equals the forward rate F (0, T1 , T2 ).
The price of a caplet is given by the following formula:
log F
+ 12 2 T1 log F
21 2 T1

N (T2 T1 ) RK RK
F RK ,
1 + L(0, T2 )T2 T1 T1
where
F = F (0, T1 , T2 ).
Difficulties with modelling interest rates
Quotations for GBP (12/04/2013):
1M 0.4925% 2M 0.4981% 3M 0.5056% 12M 0.8994%
Interdependence between rates for different maturities.

Criticism of Blacks model
Blacks model is an industry standard for pricing of caps/floors

and similar instruments.
But...
It does not allow to model dependence between prices of bonds with

different maturities.
It does not allow to model changes of bond prices (interest rates) over
time (needed, e.g., for American or path-dependent options).
Short-rate
rt = lim R(t, T )
T t
Properties:
rt is the left-most point of the yield curve at t

rt = log P (t, t)
T
Money market account
Assume
dBt = rt Bt dt
Then
Rt
ru du
Bt = B0 e 0 .
Bt is a stochastic process!!!
Pricing in short-rate models
By analogy to the Black-Scholes model there should be a risk-neutral
measure Q such that the price (at t) of any contingent claim X payable at T
equals
nX o
Bt E Q Ft .
BT
This is equivalent to
n RT o
ru du
E Q e

t X Ft .
In particular,
n RT o
ru du
P (t, T ) = E Q e

t Ft .
There is a dependence between bond prices with different maturities.
Choice of rt
The dynamics of rt under the risk-neutral measure Q should be chosen in
such a way that
n RT o
P (0, T ) = E Q e 0 ru du , T > 0.
Prices of bonds are given by the current term structure of the interest rates:
1 1 T R(0,T )
P (0, T ) = = T = e .
1 + L(0, T )T 1 + Y (0, T )
Why the physical measure P is not important?
the short-rate is not observable,
the model is calibrated to the prices of "derivative instruments" bonds.
Precise arguments: Heath-Jarrow-Morton model (see later in the notes).

First attempt - Vasicek model (1977)
drt = k rt )dt + dWt
Theorem.
P (t, T ) = A(t, T )eC(t,T )rt ,
where
1
C(t, T ) = 1 ek(T t) ,
k
n 2 2 2
o
A(t, T ) = exp 2 C(t, T ) T + t C(t, T ) .
2k 4k
The short rate rt can become negative.
The model cannot be perfectly calibrated; only four parameters: k, , , r0 .
Second attempt - CIR model (1985)

drt = k rt )dt + rt dWt
Theorem. If 2k > 2 , then rt > 0.
Under the above assumption, the short rate rt stays positive.
There are closed-form formulas for bond and standard option prices.
The model cannot be perfectly calibrated; only four parameters: k, , , r0 .
Hull-White model (1990)
Partial success:

drt = (t) art dt + dWt ,
where the function (t) and the constant a can be determined from the
present term structure (yield curve).
There are closed-form formulas for bond prices and prices of several
kinds of options.
The model can be perfectly calibrated: it can replicate all bond prices at
time 0.
The short rate rt can become negative.
Black-Karasinski (1991)
Full success?
rt = ezt ,
where

dzt = (t) a(t)zt dt + (t)dWt .
Parameters: functions (t), a(t), (t).
There are no closed-form formulas for bond prices.
Numerical methods are needed (in practice, mainly binomial and

trinomial trees).
The model can be perfectly calibrated: it can replicate all bond prices at
time 0.
The short rate rt stays always positive.
Which one to use?
Short-rate models are popular among practitioners:
due to their simplicity and computational tractability,
as a first approximation to prices of interest-rate derivatives,
for risk-management purposes.
It is hard to choose between Hull-White and Black-Karasinski: there is

evidence that interest rates are not log-normally distributed.
What next?
Heath-Jarrow-Morton modelling framework
LIBOR market model (also called Brace-Gatarek-Musiela model or BGM

model)
Replication revisited
Black-Scholes model:
stock (risky asset with random dynamics) and bond (riskless asset with
deterministic dynamics)
self-financing condition = Vt is a Q-martingale
four-step procedure = replicating strategy for any contingent claim
bond is here a numeraire - discounting asset
If both assets have random dynamics?
Two risky assets with It representations:
dGt = mt dt + ut dWt ,
dFt = t dt + t dWt ,
such that t > 0 and Gt > 0.
Remember! Risk-neutral measure, etc. are tools/tricks to get

a replicating strategy.
Ft
Choose one as a numeraire, e.g., (Gt ) and denote Ft = Gt .
A strategy (t , t ) is self-financing if
d(t Gt + t Ft ) = t dGt + t dFt .
A measure Q is called a risk-neutral measure for numeraire (Gt ) if Ft is a

Q-martingale.
Theorem. There is a Q-Brownian motion (Wt ) and a previsible process (t ):
dFt = t dWt .
Theorem. If (t , t ) is self-financing then the discounted value process
Vt t Gt + t Ft
Vt (, ) = =
Gt Gt
is a Q-martingale and
dVt = t dFt .
Rt
Theorem. If Et = E0 + 0
t dFt then the strategy (t , t ) with
t = Et t Ft
is self-financing.
SO
Four-steps approach works!
Replication
Conclusion. Let (Ft ) be the filtration generated by (Gt ) and (Ft ). For
every FT -measurable contingent claim X payable at T there is a repli-
cating strategy, i.e., a self-finacing strategy (t , t ) such that
X = T GT + T FT .
In Black-Scholes model: Gt = Bt , Ft = St , so
dGt = rGt dt + 0dWt ,

dFt = Ft dt + Ft dWt .
In short-rate models...?
Can (Ft ) be a numeraire? Yes, if Ft > 0 and ut > 0.
Short-rate models made precise
First risky asset (numeraire):
Rt
rs ds
Gt = Bt = e 0 ,
where (rt ) is an adapted stochastic process.

Second risky asset: A bond with maturity T
Ft = P (t, T ), t T .
There is a risk neutral measure Q and every contingent claim X payable

at T T is replicable with the price at t [0, T ] is given by
X
Bt E Q Ft .

BT
Conclusions
Bonds with maturities T T are contingent claims with X = 1:
1 B RT
t
P (t, T ) = Bt E Q Ft = E Q Ft = E Q e t rs ds Ft

BT BT
Their payoffs and prices can be replicated by a self-financing strategy trading
in
bonds with maturity T ,
money market account Bt .
Surprise: we do not have to provide the dynamics of the T -bond price. It is

enough to know that it is given by an It process and to know the dynamics of
(rt ) under the risk-neutral measure.
LIBOR market model
Fixed times:
T0 = 0 < T1 < T2 < < TM < TM +1 ,
with
i = Ti+1 Ti , i = 0, 1, . . . , M.
We will model M forward rates:

P (t, Ti ) P (t, Ti+1 )
Fi (t) := F (t, Ti , Ti+1 ) = .
i P (t, Ti+1 )
This is an indirect method to model bond prices:

i1
Y 1
P (Tn , Ti ) = , i = n + 1, n + 2, . . . , M + 1.
j=n
1 + j Fj (Tj )
Spot numeraire
start with 1 at t = 0 and then purchase 1/P (0, T1 ) of the zero-coupon
bonds maturing at time T1
at time T1 reinvest the funds in the zero-coupon bond maturing at time T2 ,
by continuing in this way, we see that at time t the spot numeraire will be
worth
I(t)1
Y

Bt = P (t, TI(t) ) 1 + j Fj (Tj ) ,
j=0
where I(t) is the smallest i such that Ti > t.
Spot measure
Consider two financial instruments:
spot numeraire (Bt ),
bond with maturity TM +1 .
By the general replication theory, there is a measure Q such that the process
P (t, tM +1 )
DM +1 (t) =
Bt
is a Q-martingale. This measure is called a spot measure.
Forward rate under spot measure
Assumption. There is a previsible processes i (t) and (non-random)
function i (t) such that
dFi (t) = i (t)Fi (t)dt + i (t)Fi (t)dWt ,
where (Wt ) is a Brownian motion under Q.
Theorem. There is no freedom in the choice of i (t). The pricing theory

implies that
i
X j Fj (t)i (t)j (t)
i (t) = , 0 t Ti .
1 + j Fj (t)
j=I(t)
Great news as the estimation of the drift is virtually impossible given the
amount of available data.
Pricing caplets
The price of a caplet on the rate between Ti and Ti+1 requires computation of
+

(Fi (Ti ) K)
EQ ,
BTi
where
i
X j Fj (t)i (t)j (t)
dFi (t) = Fi (t)dt + i (t)Fi (t)dWt .
1 + j Fj (t)
j=I(t)
Easy?
Trick - a forward measure
Reverse the situation:
bond with maturity TM +1 as a numeraire,
"spot numeraire" (Bt ) as a second instrument.
Theorem. There is a measure QM +1 and a QM +1 -Brownian motion

(M +1)
(Wt ) such

B t
Dt =
P (t, TM +1 )
is a QM +1 martingale and
(M +1)
dDt = t Dt dWt .
Moreover,
(M +1)
dFM (t) = FM (t)M (t)dWt .
Blacks formula
Under measure QM +1
FM (TM ) is log-normally distributed

the variance of log FM (TM ) is

Z TM
V arQM +1 log FM (TM ) = 2 (s)ds.
0
the expectation of FM (TM ) is

E QM +1 FM (TM ) = FM (0).
Hence, Blacks formula applies! And it is possible to derive dynamics of

Fi (t) under the measure QM +1 enabling pricing of instruments involving
more tenors (dates).
Summary
LIBOR market model
allows dependence between distributions of LIBOR rates are different

maturities,
preserves Blacks formula for pricing of caplets and floorlets,
describes market using quoted quantities (forward rates).

Short-Rate and Forward-Rate Models

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Lecture 9

Short-rate and forward-rate

Price of a zero-coupon bond provides a unique description of changes of the

L(t, T ) is the LIBOR rate (simple compounding)

Y (t, T ) is a yearly compounded rate

R(t, T ) is a continuously compounded rate (used commonly in models).

Rate RF is chosen in such a way that the contract is worth 0 when

Both parties have an obligation to borrow/lend at the rate RF .

The rate RF determined at t (t T1 ) equals

T1 - beginning of the period, T2 - end of the period

RK - interest rate (strike price), N - the principal

The payoff of the caplet is paid at T2 and equals

The payoff of the floorlet is paid at T2 and equals

the variance of log L(T1 , T2 ) equals 2 T1 ,

the expectation of L(T1 , T2 ) equals the forward rate F (0, T1 , T2 ).

The price of a caplet is given by the following formula:

1M 0.4925% 2M 0.4981% 3M 0.5056% 12M 0.8994%

Interdependence between rates for different maturities.

Blacks model is an industry standard for pricing of caps/floors

It does not allow to model dependence between prices of bonds with

rt is the left-most point of the yield curve at t

There is a dependence between bond prices with different maturities.

Why the physical measure P is not important?

the short-rate is not observable,

the model is calibrated to the prices of "derivative instruments" bonds.

Precise arguments: Heath-Jarrow-Morton model (see later in the notes).

drt = k rt )dt + dWt

The model cannot be perfectly calibrated; only four parameters: k, , , r0 .

Theorem. If 2k > 2 , then rt > 0.

Under the above assumption, the short rate rt stays positive.

The model cannot be perfectly calibrated; only four parameters: k, , , r0 .

The short rate rt can become negative.

There are no closed-form formulas for bond prices.

Numerical methods are needed (in practice, mainly binomial and

The short rate rt stays always positive.

It is hard to choose between Hull-White and Black-Karasinski: there is

Heath-Jarrow-Morton modelling framework

LIBOR market model (also called Brace-Gatarek-Musiela model or BGM

self-financing condition = Vt is a Q-martingale

four-step procedure = replicating strategy for any contingent claim

bond is here a numeraire - discounting asset

If both assets have random dynamics?

such that t > 0 and Gt > 0.

Remember! Risk-neutral measure, etc. are tools/tricks to get

d(t Gt + t Ft ) = t dGt + t dFt .

A measure Q is called a risk-neutral measure for numeraire (Gt ) if Ft is a

Theorem. If (t , t ) is self-financing then the discounted value process

dGt = rGt dt + 0dWt ,

Can (Ft ) be a numeraire? Yes, if Ft > 0 and ut > 0.

where (rt ) is an adapted stochastic process.

There is a risk neutral measure Q and every contingent claim X payable

bonds with maturity T ,

money market account Bt .

Surprise: we do not have to provide the dynamics of the T -bond price. It is

We will model M forward rates:

This is an indirect method to model bond prices:

at time T1 reinvest the funds in the zero-coupon bond maturing at time T2 ,

where I(t) is the smallest i such that Ti > t.

spot numeraire (Bt ),

bond with maturity TM +1 .

is a Q-martingale. This measure is called a spot measure.

dFi (t) = i (t)Fi (t)dt + i (t)Fi (t)dWt ,