Stochastic - Methods - Interest Rates - 1 PDF

Agenda
Stochastic ALM models

■ Introduction and generalities about stochastic ALM models
■ Economic Scenario Generator
● Interest rates models
■ ALM cash-flow projection
■ Other tools
1
ESG - Interest rates modelling
Agenda
■ Historical perspective
■ Important features of interest rates models
■ Vasicek and Hull-White models
● Vasicek
● Hull-White 1 factor
● 2-factors Hull-White and G2++
■ Cox-Ingersoll-Ross models
● CIR
● CIR++
● CIR2++
■ Dimension reduction techniques
● Principle Components Analysis
● Application to IR modelling under the real world measure: econometric model
● Application to the Libor Market Model
■ Price of risk modelling
2
Interest rates modelling
Historical perspective
§ Interest rates models:

§ Most well known models have been developed in the framework of interest rates
option pricing
§ First interest rate option pricing model: Black ’76
§ Straightforward adaptation of Black-Scholes-Merton formula/model in order to price
plain vanilla interest rate options (European caps/floors and swaptions)
§ Assumes that the underlying rate of the option follows a log-normal distribution, like
the stock price in Black-Scholes-Merton model
§ Analytical formulas for prices of caps and swaptions
§ “Black 76 formula”
§ Not well adapted to the pricing of exotic options in general (mainly due to the smile
phenomenon in the market)
§ Not adapted to negative interest rates (a log-normal variable is always positive)
à other pricing models were developed BUT the model was/is still used to express
market prices through the “implied Black volatility” (if non negative underlying rate)
3
■ First generation of pricing models: endogeneous short rate models

● One factor models, based on the short rate dynamics
● The curve for other maturities evolves as a (deterministic) function of the
short rate
Ó Once the short rate is known, the entire curve is known
● Analytical tractability and convenient modelling:
Ó theprice (and the dynamics) of zero-coupon bonds can be deduced from the
dynamics of the short rate itself
● The model can be directly specified under the risk neutral measure (when
used for pricing purpose), without specific arbitrage condition to add
Ó No drift-volatility condition like in HJM model
Ó This condition is however implicitly used for deducing the price of zero-coupon bonds
from the short rate level, and of other interest rates products
4
■ First generation of pricing models – Examples:

● The first « true » interest rate model: Vasicek in 1977
● Dothan model in 1978: log-normal rates, no mean reversion
● Exponential-Vasicek : log-normal rates with mean reversion
● Cox-Ingersoll-Ross in 1985
■ These first models are qualified « endogeneous »: the initial yield curve
(at t=0) is an output of the model rather than an input
● As a consequence, the initial yield curve of the model does not perfectly
match the market yield curve
● Sometimes, the mismatch is important (e.g. constant curve can not be
match in a Vasicek model)
5
■ Second generation : exogeneous models

● The initial yield curve of the market is taken as an input, and is part of the
« parameters » of the model
Ó Perfect calibration (of the risk neutral dynamics) on the initial market yield curve
● Other parameters of the model (generally not numerous) can be calibrated
on a set of plain vanilla interest rates options quoted in the market
Ó Typically European swaptions and/or caps/floors, depending on the context of the
model development
Ó The calibration process consists to minimize the distance between model and market
prices of a set of interest rates options
6
■ Examples:
● Gaussian additive models: Hull-White, G2++ (Gn++)
● Square root volatility models: CIRn++ (1-factor CIR++, 2 factors CIR2++…)
● Black-Karasinski
● Rem: these models can be considered in the more general framework of

Heath-Jarrow-Morton. Each one correspond to a specific form of the
volatility function (…)
7
■ Third generation of pricing models: market models

● Developed before the 2008 crisis in order to ease calibration on vanilla
options (on caps/floors or on swaptions)
● The model specifies the dynamics of a set of reference rates, which are the
underlying of the options quoted in the market
Ó Options used for the calibration and the hedging (of one of the counterparty)
Ó Libor-type rates (underlying caps and floors)
Ó Par swap rates (swaps on the Libor-type rates)
Ó Libor market model, swap market model
● Directly inspired from Black 76 model, but « true » models

Ó The dynamics of the entire yield curve is addressed within an arbitrage free framework
● Calibration performed on the initial yield curve AND a set of caps or
swaptions (good or even perfect calibration)
● Many formulations:
Ó Number of factors, market on which it will be calibrated
Ó Specific form of the volatility functions
Ó Use of specific analytical approximations
8
■ Fourth generation: multicurve models

● The preceding models deal with unicurve modelling, i.e. the modelling of a
unique interbank yield curve considered ‘risk free’, i.e. without credit risk
Ó Rem: risk free does not mean deterministic here!
● Actually, interbank rates like Euribor or par swap rates are linked with
operations between (a panel of large) banks, not considered as totally risk
free anymore since the 2008 crisis
● The only (interbank) curve considered as being ‘risk-free’ is the curve
obtained from OIS rates
Ó OIS = Overnight Index Swaps, i.e. swaps in which the floating leg depends on an
overnight rate, EIONIA in the Eurozone
● There is a (liquidity and credit) spread between reference rates underlying
IR derivatives (e.g. Euribor rates) and the pure risk free rates (OIS curve)
● This impacts in practice the (clean) construction of zero-curve from swap
and Euribor rates, but also the pricing of these derivatives
9

● Concretely, within the pricing of an interest rate derivatives:
Ó the OIS curve is still used for discounting (the idea is that funding is made through
overnight loans), BUT
Ó the cash-flows of the product, based on Euribor rates, are projected using a model for
the dynamics of this second curve
à Use of 2 different curves (different evolution in time) for discounting and for projecting
the future cash-flows
● New pricing formulae and methodologies requiring a distinction between
rates used for discounting and rates used for projecting cash-flows of the
products
● The OIS curve is first constructed from OIS rates existing for different
maturities, based on the specificities of a OIS
10
■ Specificities of an OIS:
● Overnight index swap: swap in which a fixed rate is exchanged against a
variable rate obtained from the different EIONIA rates on that period
● Variable rate !" of the OIS:
/01234
360 !+ ∗ -+
!" = ( 1+ −1
' 360
+5/67897
● :;/<=/ = start date,
● :>?@ = end date,
● !+ = EIONIA fixing rate on the ith day
● -+ = number of days for which !+ is applied (1 day during the week, 3
days for week-ends
● ' = total number of days of the OIS
11

● The spread between OIS curves and other interbank curves (deduced
from swap rates on other floating rates, e.g. swaps on Euribor 3M, for the
EUR3M curve, or on Euribor 6M etc) is increasing and has become
variable since the 2008-2009 crisis
Source: Ridwan Nori master thesis, ULB, 2015

12
■ Fourth generation: Multicurve models

● Different curves need to be modeled simultaneously
Ó thedynamics of (at least) 2 curves is required, taking into account dependencies
between both
Ó Sometimes, the different curves are modelled, sometimes the spread…
● In order to maintain model complexity acceptable, and in particular a

manageable number of parameters, second generation models are used
again, but within the multicurve environment
Ó E.g.Hull-White or G2++ for modelling the different curves, or for modelling the OIS
curve and the spread between the other relevant curves (e.g. EUR3M curve) and the
OIS
13
■ We mentioned here continuous time models developed for the purpose of

option pricing, which is relevant for computing an “economic” or “market
consistent” balance sheet (in presence of embedded options)
■ In practice, insurance companies also need models for quantifying interest
rate risk on a given time horizon
● Providing the dynamics of the yield curve under the real world measure
■ As both types of MC simulations (real world and risk neutral) are generally
required, it can be convenient to work with a unique model, e.g. G2++, but
parameterized differently, for both types of projections
● This is also the preference of some regulators – no consensus…
■ Moreover, the first pricing models were historically specified under the
real world measure, with an ‘appropriate’ assumption on the price of risk,
allowing to derive the dynamics under a risk neutral measure
● E.g. Vasicek model, assuming a constant price of risk
● These models tried to take into account empirical properties of time series, that should be
reflected by the real world dynamics, but not necessarily at the level of the risk neutral one 14
■ Another option is to use different models for risk management and pricing
purposes
■ To measure risk, the non-arbitrage constraint is not present
■ It is usual that the models used for risk management purposes are based
on econometric methods, generally in discrete time
● These use building blocks like ARIMA, mean reversion, distribution fitting,
use of PCA for reducing the dimensionality, …
● The building blocks can however be similar those used within continuous
time models (e.g. Vasicek and AR1)
■ The aim of the next slides is to recall some important features of a few
basic interest rates models in continuous time, with a focus on calibration
● Both of the risk neutral and the real world dynamics
● Modelling of the price of risk will be discussed
● Focus on some specific models for illustration
15
Agenda
● Vasicek
● CIR
● CIR++
● CIR2++
● Application to IR modelling under the real world measure
16
Interest rates modelling : features of IR models
When choosing an IR model, different important questions must be addressed:

§ Mean reversion § Shape of the implied volatility
● Expected value of the short rate term structure
tends to a deterministic level with
time, without exploding variance § Possibility to perform easy
historical calibration
§ Positivity of rates and explicit
distribution of the short rate § Can we easily perform Monte-
Carlo simulations ?
§ Possibility to perfectly fit the ● For pricing path-dependent options,
initial yield curve or complex European options
§ Ease of calibration on the § Can we build recombining
market lattices?
● Explicit formulae for ZC bonds and ● For pricing options with early
European options on ZC bonds exercise (Bermudan, American,
(àexplicit formulae for caps and/or flexible options…)
swaptions)?
2018-2019 17
When choosing an IR model, different properties and questions must be

addressed:
■ Use of the model for valuation purpose (market consistent valuation)
● Ability to perfectly fit the initial yield curve
Ó This is an absolute requirement
● Ease of calibration on the (rest of the) market
Ó Explicitformulae for ZC bonds : this is not the case for Black-Karasinski for instance
Ó And for European options on ZC bonds (explicit formulae for caps and/or
swaptions): this is not the case of CIR2++, nor LMM (in many versions) for swaption
prices
¦ Passing to analytical approximations is then a potential solution
Ó Flexibility in the shape of the implied volatility term structure
18

addressed:
■ Use of the model for risk measurement and management purposes
● Ability of the model to reproduce empirical features of interest rates?
Ó Mean reversion properties: expected value of the short rate tends to a constant,
without exploding the variance
Ó Time varying variance
Ó Non perfect correlation between rates corresponding to different maturities
Ó Negative rates
¦ This is not a requirement anymore in the current low (and negative) rates context
¦ Remark that this has never been an absolute requirement in the context of option pricing
¦ Many models allow negative rates (Vasicek, Hull-White, G2++, CIR++, some versions of
the LMM)
● Possibility to perform robust historical calibration
19

addressed:
■ Possibility to build a consistent real-world / risk neutral framework
● This is more a theoretical requirement
Ó In theory, passing to an equivalent measure cannot change the volatility coefficient in
the SDEs
Ó In practice, a model tries to answer to specific questions, and is always a simplification
of reality (so it is always “false”)
Ó Different questions might be addressed by different models
¦ Remark that there is no consensus about that fact
■ Can we easily perform Monte-Carlo simulations ?

● For pricing path-dependent options, or complex European options
● For computing risk measurement
■ Can we build recombining trees?
● For pricing options with early exercise (Bermudan, American,…)
20
Agenda
■ Notations and definitions
● Vasicek
● CIR
● CIR++
● CIR2++
21
Vasicek model
■ This section recalls the main properties of the Vasicek model
■ The short rate is supposed to follow an Ornstein-Uhlenbeck (OU) process:

!"# = % & − "# !( + *!+ (
● % > 0, * > 0, & ∈ ℝ are constant parameters
■ Historically, Vasicek introduces the dynamics under the real world

measure and shows the existence of a risk neutral measure, assuming in
addition a constant price of risk (see later)
■ Attractive model: this SDE can be solved explicitly :
2
12 = 13 4562 + 7 8 − 4562 + 94562 : 46; <=(;)
3
Deterministic trend Stochastic noise

(Gaussian)
22
Vasicek model
■ Solving the OU SDE:
23
Vasicek model
■ Solving the OU SDE:
24
Vasicek model
§ Illustration (1/3)
§ in red: the deterministic trend (see previous slide).

25
Vasicek model
26
Vasicek model
● ! = 50%, ' = 1%, ) = 0.7%, ,- = 0.5%
-3
x 10
11
10
4
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
● in red: the deterministic trend – it is quite concave here because the mean reversion
speed « a » is larger and because the initial rate is smaller than the long term target
27
Vasicek model
§ The short rate follows hence a Gaussian distribution, with explicit

formulae for the mean and variance:
!" # = "% &'(# + * + − &'(#

# /
.
-(" " # = ./ &'/(# 0 &/(1 21 = (+ − &'/(# )
% /(
§ In particular, the asymptotic mean and variance are given by:
./
lim : " # = * , lim -(" " # =
#→9 #→9 /(
● Rem: We see that the variance of the short rate is hence governed by
both the volatility parameter = AND the mean reversion speed >
● Volatility of the short rate increases with . and decreases with (
28
Vasicek model
§ Same type of result for the conditional distributions :
"
!" = !$ %&'("&$) + + , − %&' "&$
+ . / %&' "&0
12(0)
$
3 !" !$ = !$ %&'("&$) + + , − %&' "&$
.5
4'! !" !$ = , − %&5' "&$
5'
29
Vasicek model
§ Main properties:
§ Mean reversion property, towards a constant mean reversion level b
§ Gaussian distribution for the short rate and zero-coupon rates of all
maturities (Gaussian short rate and affine model)
à Good analytical tractability (normal law is convenient)
à Possibility to get negative rates
§ One-factor model: rates of all maturities are perfectly correlated
§ Analytical formulae for prices of zero-coupons, but also European

options on ZC bonds (and hence of swaptions and caps/floors)
30
Vasicek model
§ Price of zero-coupon bonds and risk neutral measure:

§ Assuming that the price of risk is constant, equal to !, Vasicek emphasizes
the existence of an equivalent probability measure ℚ , called risk neutral,
and obtained by applying Girsanov theorem with measure change:
§ Under this new measure, the dynamics of the short rate has the same form
(OU process) as before, but constants are slightly modified:
*-
%&' = %&) , *&' = *&) , +&' = +&) −
%
:
● By the NAO assumption, . /, 0 = 1ℚ exp − ∫; 67 89 | ℱ; , and this
can be computed explicitly thanks to the analytical solution for 6; and its
properties
31
Vasicek model
§ Price of zero-coupon bonds and risk neutral measure:

§ Analytical expression for zero-coupon bonds:
! ", $ = & ", $ ' () *,+ ,-
with:
34 34 4
& ", $ = exp 1− 4 7 ", $ − $ + " − 7 ", $
26 46
1
7 ", $ = 1 − ' (; +(*
6
and where 6, 1, 3 are the model parameters under ℚ
■ The yield curve at t is hence a function of 3 elements:
● the short rate at t, => ,
● the time to maturity s-t,
● and the 3 model parameters (under the risk neutral measure):
ln !(", $)
? ", $ = − = E(6, 1, 3, F* , $ − ")
$−"
32
Vasicek model
■ Price of zero-coupon bonds and risk neutral measure:

● Analytical expression for zero-coupon bonds:
! ", $ = & ", $ ' () *,+ ,-
= ' ./(*,+)() *,+ ,-
with:
6 56
2 ", $ = 3 − 5 6
Ó& 9 ", $ − $ + " − 9 ", $ 7
78 ;8
<
Ó9 ", $ = 8 1 − ' (8 +(* >0
● Hence, the rate at t for maturity date s is a linear (affine) function of the short
rate:
ln ! ", $ 9 ", $ &2 ", $
@ ", $ = − = D* −
$−" $−" $−"
● Since the short rate is Gaussian, the ZC rate of any maturity is also
Gaussian
● Rates of all maturities are perfectly correlated
33
Vasicek model
■ Shape of the yield curve:
-.
■ Developing the formulae for !(#, %) and '(#, %) and setting () ≔ + −
./.
leads to:
in which () = 123%→) ((#, %) is the “ultimate” long term rate

■ We see from this expression that the yield curve can never be constant
(horizontal) in this model
■ (See example)
34
Vasicek model: dynamics of a ZC bond
■ We can get the dynamics of the price of a ZC bond using the Itô lemma
applied to function :
! ", $% = '()(+,(", -) − 0 ", - $% )
■ We then get after calculation:
12 ", - = $% 2(", -)1" − 30 ", - 2(", -)14 ∗ "

where W*(t) is a standard Brownian motion under the risk-neutral
measure ℚ
■ Coming back to the RW probability measure (W t = W ∗ " + :" is a
standard BM, without drift under ℙ):
12 ", - = 2 ", - ($% +:30 ", - 1" − 30 ", - 14 " ]

Risk premium Negative à Not surprising: if rates
increase, ZC prices decrease
35
Vasicek model
■ Although this model has several drawbacks for the purpose of Interest
rates modelling, it is still used as a building block for other more
complex models
● Hence it remains a topic of interest
■ In particular, a direct extension of this model is the Hull-White model:
!"# = % & − "# !# + )!*#
!"# = % + # − "# !# + )!*#

where %, ) > . and +(#) deterministic, calibrated from the initial yield
curve (see later)
● This new model is better adapted for option pricing purposes
● Many results obtained for Vasicek are re-used for HW1
36
Vasicek model: Calibration
■ We focus now on the calibration of Vasicek model

■ The calibration methodology depends on which purpose the model is
used
■ For risk management purpose, if the aim is to compute a risk measure
(for regulatory capital for instance), then we are actually interested in the
parameters of the real world dynamics
■ The most natural choice appears to use historical data, involving time
periods in line with the time horizon of the risk measures
■ We discuss in what follows calibration of Vasicek on historical data,
focussing hence on the real world dynamics
● Least square / linear regression - AR1
● Maximum likelihood estimation
37
Real world dynamics calibration: Linear regression / AR1

■ Methodology motivated by the analytical solution obtained for the short
rate
● Let us recall the explicit solution of the SDE of the short rate:
"
!" = !$ %&'("&$) + + , − %&' "&$
+ . / %&' "&0
12(0)
$
● The last term is the stochastic integral of a deterministic function, hence it is
Gaussian with mean zero and variance given by the Ito isometry:
Ó Ito isometry says indeed that :
8 : 8
3 / 4 5 67 5 = 3 / 4 : 5 65
9 9
which leads here to:
$ < $ &<'("&$)
, − %
; . / %&'("&0) 12 0 = .< ; / %&<'("&0) 1" = .<
" " <'
38

● In consequence, if !"#$ > !" , we have:
* − ,-5./'
&'()* = &'( ,-./0 + 2 * − ,-./' + 4 6(
5.
● where 7" i.i.d. N(0,1), and Δ! = !"#$ − !" (assumed constant)
● This can be seen as an AR(1) model: :(#* = ;< :( + ;* + =( ,

where ?" i.i.d. gaussian with mean 0, and
;< = ,-./0
;* = 2 * − ,-./'
* − ,-5./'
@'A,B =( =4
5.
39

● An alternative is to depart from the Euler scheme of the SDE for the short rate:
!"#$% = !"# +( ) − !"# Δ, +-ΔW/
● This can be seen as another AR(1) model: 0123 = 45 01 + 43 + 61 ,

where 61 i.i.d. gaussian with mean 0, and:
45 = 1 − (Δt
9 43 = ()Δt
<,=>? 61 = - Δt
● Actually this model is the 1st order approximation of the previous AR(1) model
3 3
● In practice, when Δ, = B! 3@, there is no material difference between both
@A5
approaches…
40

● Estimation of the parameters of an AR1 model can be done using linear
regression techniques
● Indeed, this can be seen as a linear model of the type :
! = #$ + & + '(()(*
where X denotes the observations on one day, and Y the observations on
the next day
● If we consider such a linear model, estimation of the parameters can be
obtained using different techniques, the simplest one of them being
standard Ordinary Least Square estimation (OLS)
Ó consistingto minimize the square of errors between the real observations of Y and
the approximation of these observations by #$ + &
41

● The idea of OLS is to find the « best » parameters a, b in a linear model of
the type:
! = #$ + & + '
by minimizing the sum of squares differences between the observed values
of Y (the « real values » of Y) and the linear approximation of Y by aX+b
42

● The objective function (i.e. the function to minimize) is:
,
! ", $ = & '( − "*( − $ +
(-.
● By derivating !(", $) with respect to a and b, and equalling the

derivatives to 0, we find the minimum. This leads to the standard OLS
solution:
234 5, 6
"1 = + = ":; $ = '< − "1*̅
78
. .
where 234 5, 6 = , ∑,(-.(*( − *̅ )('( − '<), 78+ = , ∑,(-. *( − *̅ +
and *̅ , '< are the sample means of X and Y
43

■ Illustration on the period [1999- 2014] on EUR1M
● Left: Use of monthly data - Right: use of daily data
EUR1M9914-Ornstein Uhlenbeck - monthly data EUR1M9914-Ornstein Uhlenbeck - daily data

0.06 0.06
0.04
0.04
0.02
0.02
0 Historical Rates Historical
Regression Regression
-0.02 0
0 0.01 0.02 0.03 0.04 0.05 0.06 0 0.01 0.02 0.03 0.04 0.05 0.06
Residuals-OU x 10
-3 Residuals-OU
0.01 10
0.005
5
0
0
-0.005
-0.01 -5
0 20 40 60 80 100 120 140 160 180 200 0 500 1000 1500 2000 2500 3000 3500 4000 4500
44

■ Illustration : History (red) vs model simulation (blue) from the past, until EOY 2014
0.07
0.06
0.05
0.04
0.03
0.02
0.01
-0.01
-0.02
-0.03
01/01/95 01/01/00 01/01/05 01/01/10 01/01/15
45

■ Illustration: Short rate distribution end 2015 based on different calibration periods
(simulation from EUR1M EOY 2014 = 0.21%)
1999-2014 2005-2014 2007-2014 2010-2014

Percentiles (16 years) (10 years) (8 years) (5 years)
1999- 2005- 2007- 2010-
0.01 -1.72% -1.85% -1.75% -0.69%
2014 2014 2014 2014
0.05 -1.18% -1.27% -1.25% -0.47%
a 5.29% 6.61% 15.30% 14.64%
0.1 -0.92% -0.99% -0.99% -0.36%
0.25 -0.51% -0.55% -0.61% -0.19% b -1.52% -1.46% -1.45% -0.11%
0.5 -0.04% -0.06% -0.17% 0.01% sigma 0.70% 0.74% 0.70% 0.31%
0.75 0.44% 0.46% 0.29% 0.21%
0.9 0.86% 0.91% 0.68% 0.39%
0.95 1.10% 1.17% 0.91% 0.49% – There seems to be a change of regime from 2010…
0.99 1.59% 1.70% 1.37% 0.69% feature that a simple Vasicek model is not able to capture,
0.995 1.73% 1.85% 1.52% 0.76% as it only allows one set of parameters whatever the level
mean -0.038% -0.048% -0.160% 0.012%
Std dev 0.68% 0.72% 0.65% 0.29%
of rates
– Calibration leads to a kind of « average » of the mean

reversion speed and target, and volatility characteristics
over the whole period considered
46
■ The period considered here (1999-2014) although not so short (15 years),
is characterized by rates moving globally downward
● As a consequence, the mean reversion target tends to be quite negative
(also when considering different time periods). This is less an issue if the
projection period is around 1 year, but a potential issue for a multiyear
projection model (e.g. 5 years)
■ In general parameters are quite sensitive to the period considered
■ The rate distribution itself is reasonably sensitive, except if we focus on
the period after 2010 (the EUR crisis)
■ The use of monthly vs daily data has also an impact (although it should
not in theory)
■ Mean reversion seems to hold in general
47
■ Normality of errors is however questionable: statistical testing (e.g. KS

testing) shows that the normality hypothesis is rejected for residuals…
● In consequence, using a mean reverting Gaussian model for the real
world dynamics appears not ideal…
● But other mean reversion models could be considered
■ One can see that estimation from daily data leads to negative mean
reversion speeds (for some historical periods, in particular 1999-2014)
à no mean reversion but exploding version of the model…!
48
Interest rates modelling*
Real world dynamics calibration: Maximum Likelihood Estimation

■ MLE calibration
● Based on the available analytical formula for the conditional density of the
short rate
● The likelihood function is computed for a given time series of length N
(!"#$ , & = 0,1, … , +):
7
- . = / 0(! "23 #$ |!5#6 , .)

"83
where . = 9, :, ; and p(.,.,.) are the transition densities
● Here we know that:

C ?C@#$
; 1 − >
!("23)#$ |!5#6 ∼ + : 1 − > ?@#$ + > ?@#$ !5#6 ,
29
49
● One can see that the likelihood function constructed on a sample

!" "#$,…,' of i.i.d observations of a Gaussian distribution ( ), * + is:
' '
1 45 36 7
3
, ), * = 1 2 +87
20* + "#$
and the log-likelihood is: '
+
> > +
!" − )
ln (, ), * = − ln 20 − ln * + @ −
2 2 2* +
"#$
50
In the current case, this leads to the analytical form of the log-likelihood:
>
' ' *+ 1
ln # $ = − ln 2) − ln 1 − . /+012 − 3 4 + (67 , 679: , Δ<)
2 2 2, 2
7?:
where:
/012
2,
4 67 , 679: , Δ< = 6 79: 1@ − (A + 6712 − A . ) + /+012
* 1−.
and where N+1 is the length of the time series (so we have N transitions)
Note: here DE stands for DEFG 51

Making the following change of parameters:

+ / .
! = # $%&' , * = , - . = (1 − # $.%&' )
, 2,
one can see that MLE estimators for !, *, - . are obtained by:
6 ∑; 8 8
9<: 9 9$: − ( ∑ ;
8
9<: 9 )( ∑ ;
9<: 89$: )
!5 = .
6 ∑; 8 .
9<: 9$: − ;
∑9<: 89$:
∑;
9<:(89 − !
589$: )
=
*=
;
6(1 − !5)
> 1 .
- = ? 89 − !589$: − *= 1 − !5
.
6
9<: 52
■ Risk neutral dynamics calibration

● We assume here that we directly focus on the RN dynamics (without
making the link with parameters estimated for the RW dynamics)
Ó We will come back on that topic later
● Step 1: we impose that the model initial yield curve is as close as possible
to the market yield curve
Ó Thiscan be done numerically by using the explicit formula for ZC bonds or rates, and
minimize a given objective function.
● E.g. :
1
min ((*+$,-./0 0, 5- ; 7, 8, 9 − *;$<0/= (0, 5- ))²

$,&,'
-23
53
■ Risk neutral dynamics calibration

● Step 2: We can also require in addition that model prices of a set of
quoted options (e.g. caps or swaptions, depending on the problem) are as
close as possible to the market prices of these products
● Generally however, for the purpose of option pricing / market consistent

valuation, this leads to a poor calibration quality, since even the initial yield
curve may be poorly fitted
Ó For instance, a constant yield curve cannot be reached, changes in the concavity
also not…
à we generally directly pass to the extended version of Vasicek: the Hull-

White model
54
Vasicek model: Drawbacks
■ Main drawbacks of Vasicek model as a pricing model or risk model:

● The model cannot perfectly fit the initial yield curve given by the market
Ó Some market yield curves cannot be fitted with « reasonable » values of the parameters,
and some shapes cannot be reached whatever the parameters values
¦ Example: a flat yield curve
Ó This
is solved by the extension proposed by Hull-White, considering a time dependent
mean reversion target
● Gaussian model: spot rates for all maturities are Gaussian

à possibilityof negative rates, which was seen previously as a drawback when rates have
high positive levels… Actually, another issue is the level of negative rates: we can get a
lot of negative rates with high absolute value (there is no downward limit)
à Beside this, normality of errors in the discretized AR1 vision is rejected systematically
● 1-factor model à perfect correlation between ZC rates of different maturities

Ó This is not in line with observations
Ó The Gaussian 2-factors model (G2) is a natural extension, allowing some de-correlation.
It can be extended in a 3 factors version as well… 55
Vasicek model: Drawbacks
■ Main drawbacks of Vasicek model as a pricing model or risk model:

● Correlation matrix of rate changes from one month to the other:
monthly
1 2 3 4 5 6 7 8 9 10 12 15 20
changes
1 100.00% 93.90% 87.90% 80.97% 75.00% 69.75% 65.23% 61.50% 57.39% 54.49% 48.38% 41.77% 39.89%
2 93.90% 100.00% 97.89% 93.17% 88.00% 83.25% 79.00% 75.21% 71.00% 68.03% 61.36% 53.42% 52.10%
3 87.90% 97.89% 100.00% 98.18% 94.97% 91.58% 88.11% 84.88% 81.23% 78.59% 72.46% 64.86% 63.06%
4 80.97% 93.17% 98.18% 100.00% 98.92% 96.92% 94.54% 91.97% 89.08% 86.88% 81.72% 74.87% 72.33%
5 75.00% 88.00% 94.97% 98.92% 100.00% 99.36% 98.04% 96.28% 94.16% 92.38% 88.12% 81.85% 78.73%
6 69.75% 83.25% 91.58% 96.92% 99.36% 100.00% 99.52% 98.45% 97.05% 95.61% 92.19% 86.52% 83.41%
7 65.23% 79.00% 88.11% 94.54% 98.04% 99.52% 100.00% 99.61% 98.81% 97.84% 95.24% 90.37% 87.27%
8 61.50% 75.21% 84.88% 91.97% 96.28% 98.45% 99.61% 100.00% 99.66% 99.17% 97.23% 93.05% 89.73%
9 57.39% 71.00% 81.23% 89.08% 94.16% 97.05% 98.81% 99.66% 100.00% 99.72% 98.48% 94.95% 91.61%
10 54.49% 68.03% 78.59% 86.88% 92.38% 95.61% 97.84% 99.17% 99.72% 100.00% 99.31% 96.43% 93.27%
12 48.38% 61.36% 72.46% 81.72% 88.12% 92.19% 95.24% 97.23% 98.48% 99.31% 100.00% 98.58% 96.04%
15 41.77% 53.42% 64.86% 74.87% 81.85% 86.52% 90.37% 93.05% 94.95% 96.43% 98.58% 100.00% 98.11%
20 39.89% 52.10% 63.06% 72.33% 78.73% 83.41% 87.27% 89.73% 91.61% 93.27% 96.04% 98.11% 100.00%
(estimation from 2007-2014 ZC rates bootstrapped from swap rates)
56
Agenda
● Vasicek
● CIR
● CIR++
● CIR2++
57
Hull-White model
■ A model answering to the drawback of the poor fit of the initial yield
curve is given by Hull-White extension
■ Actually, the first model with an exogeneous term structure is given by
Ho-Lee (1986)
● But even in its continuous limit, no mean reversion, although this appears
to be an interesting characteristic
■ Hull and White (1990) propose an extension of the Vasicek model, a
model that can be fitted on any initial market yield curve
■ The main extension of Hull and White contains a mean reversion target
depending on time: θ(t)
■ Other extensions with volatility also depending on time: ! "
58
Hull-White model: Definition
■ The idea is to replace the constant mean reversion target by a function

of time !(#):
%&# = ( ! # − &# %# + +%,#
where (, + > / and !(#) deterministic, calibrated from the initial yield
curve:
where 01 (#) is the instantaneous forward curve observed by the market,

and linked to the zero-curve spot curve by:
%(23 (5 1 (#))
01 # = −
%#
■ We are actually directly working here under a risk neutral measure ℚ
Note: be careful on the specification of the model: 7 inside or outside the (.) 59
■ Equivalent formulation, more convenient in many practical situations

(including for simulation and calibration purposes):
■ The short rate appears as the sum of a deterministic process ! " and
an OU (Vasicek) process with zero mean reversion target, and same
mean reversion speed # and volatility parameter %
● This process & " appears as a Gaussian perturbation around a
deterministic function !(")
■ The last equation guarantees perfect calibration on the initial yield curve,
whatever the values of other parameters
60
■ Solution of the EDS for r(t):
■ Note: very similar to the solution of the OU (Vasicek) equation:
■ This implies Gaussian short rates, with explicit expressions for the
moments (deduced again from the properties of the Itô integral above):
61
Hull-White model – Price of a zero-coupon
■ Explicit formula for the price of a ZC bond:
where !" ($, &) is the market price at t=0 of a ZC bond of maturity date t
■ This is used in practice within an ESG for simulating the entire yield
curve from the simulation of the short rate only
● No need to use different Euler schemes for other rates
■ This can be written as: PZC (t , s ) = exp( A(t , s ) - B (t , s ) r (t ))
with :
1 - e - a ( s -t )
B (t , s ) =
Affine model, with all a
rates being Gaussian P M (0, s ) s2
A(t , s ) = ln M + B (t , s ) f (0, t ) - 3 (1 - e - a ( s -t ) ) 2 (1 - e - 2 at )
P (0, t ) 4a
62
Hull-White model – Probability to get negative rates
§ All zero-coupon rates have a Gaussian distribution à negative rates

§ Using the Gaussian property and the explicit form for the variance and mean, the
probability to get negative rates is easily obtained by:
é ù
ê a (t ) ú s2
P[r (t ) < 0] = F ê - ú, where a (t) = f M
(0, t ) + (1 - e -at ) 2
ê s2 - 2 at ú
2a 2
ê (1 - e )ú
ë 2a û
à possibility to measure this probability explicitly a priori, before any use of the model
for practical application
● This level was low when rates where still high and positive (15 years ago)
● High in practice when rates are low in the market (i.e. after calibration on that market),
and especially when short maturity rates are negative…
§ This formula can be directly extended to get the probability of rates below a given
negative threshold (e.g. below -2%)
63
Hull-White model: Calibration of the risk-neutral dynamics
§ Zero-coupon bonds have analytical formulae

§ Options on zero-coupon bonds and on coupon bonds have also explicit
formulations
à « Easy » (risk neutral dynamics) calibration on the market, in 2 steps:
§ First Step: We impose that θ(t) (or !(#)) follows the adequate expression
§ Dedicated function in the code, function of the other parameters and the initial yield
curve
§ Second Step: Minimization of the sum of square differences between
market and model prices of a set of swaptions
( )
M
Min å Swpt i
HW
- Swpt i
market 2
a ,s
i =1
à Need for an analytical expression for the price of a European
swaption in the model (although it becomes possible now to use MC
within calibration) and need for an optimisation process
64
■ Focus on step 1:
● The initial market instantaneous forward rate curve is required (! " (0, &)).
● It can be directly obtained by differentiating numerically the initial spot
yield curve, or by differentiating analytically the initial yield curve after a
parametric fit (smoothing)
+ ,- .(/,0)
● Recall the link between ! " (0, &) and ((0, &): !" 0, & = − +0
■ Focus on step 2:
● A swaptions (or caps/floors) pricer in the model is required for that step
● Ideally calculating by means of an analytical formula such a price
● Such a formula exist in the case of HW model
● Note that not all models do have such an analytical formula, leading to use
approximations or even MC simulations
65
Price of a payer swaption in Hull-White model ([BM]):

Payer swaption(t , T , T1 ,..., Tn , N , K ) = N å c ZBP(t , T , T , K )
i =1...n
i i i
Where:
(ZBP(t,T,S,K): price at t of a put of
ZBP (t , T , S , K ) = KPZC (t , T )F (- d + s P ) - PZC (t , S )F (- d ) maturity T and strike K on a ZC bond of
maturity S>T (underlying price : P(T,S))
1 - e - 2 a (T -t ) 1 - e - a ( S -T ) 1 P (t , S ) s
sP =s ;d = ln ZC + P
2a a s P PZC (t , T ) K 2
1 - exp(- a (Ti - T )) *
K i = A(T , Ti ) exp(- r ) = P (T , Ti , r*)
a
P M (0, T ) æ 1 - exp(- a (T - t )) æ M s 2
1 - exp(- a (T - t )) ö ö
A(t , T ) = M expçç çç f (0, t ) - (1 - exp(-2at )) ÷÷ ÷
÷
P (0, t ) è a è 4a a ø ø
$
and where r * is the solution of : ! "# ' (, (# , * ∗ = 1
#%&
where "# = . (# − (#0& for 1 = 1, … , 3 − 1 and "$ = 1 + .(($ − ($0& )
66
Comments on that formula:

■ This Black-Scholes like formula is obtained by remarking first that a
(payer) swaption can be seen as a put on a coupon bond:
● Indeed, the payoff of a swaption (nominal 1) at maturity T is !"#$ % , i.e.
by rewriting the floating leg of the swap as 1 − ( 0, +, :
%
,
1 − . / +0 − +012 ( +, +0 + ( 0, +,
032
= (1 − 78 +, +2 , … , +, , ., : = 1) %
where we see appearing the payoff of a put on a bond with coupon rate
., nominal 1 and instants of cash-flows +2 , … , +, , and put strike 1
■ The second step is to use the Jamshidian decomposition methodology
67

■ Jamshidian decomposition methodology:
● Let us consider a put of strike X, maturity T, on a coupon bond with n
instants of payments !" , … , !% , and cash-flows &' (corresponding to the
coupons and the notional for the last payment(*)).
● Then the payoff at T of a put on that bond is :
.
(− ∑%'+" &' , !, !' , - !
● The idea of Jamshidian is to see that , !, !' , - is a strictly decreasing
function of -, and to introduce - ∗ as the solution of :
%
2 &' , !, !' , - ∗ = (
'+"
● Remark that in our case, the strike of the coupon bonds put is ( = 1
(∗)
&' = 6 !' − !'7" for 8 = 1, … , 9 − 1 and &% = 1 + 6(!% − !%7" )
68

■ Jamshidian decomposition methodology (cont’d):
● Using that ! ∗ , the payoff can be written as:
. .
∑(')* &' + ,, ,' , ! ∗ − ∑(')* &' + ,, ,' , ! , = ∑(')* &' (+ ,, ,' , ! ∗ − + ,, ,' , ! ,
● Now, in general 1 + 3 . ≠ 1 . + 3 .
Ó Choose for instant 1 = −2 , 3 = 1:
¦ 1+3 . = −2 + 1 . = −1 . = 0, but 1 . + 3 . = −2 . + 1 . =1
● But it works if all the terms have the same sign… then 1 + 3 . = 1 . + 3 .
● This is the case here: since + ,, ,' , ! is a strictly decreasing function of !,
we have:
+ ,, ,' , ! ∗ − + ,, ,' , ! , > 0 ↔ ! ∗ < !(,)
where the last condition does not depend on =…
● This implies that all terms have the same sign, and that we can put the sum
outside the positive part . . 69

■ Jamshidian decomposition methodology (cont’d):
● So the payoff of the coupon bond put becomes (using also !" > 0):
'
∗ 1
& !" (+ ,, ," , . − + ,, ," , . ,
"()
i.e. the sum of ZC bonds puts with maturity T and strikes 2" = +(,, ," , . ∗ ).
● So the price of a (payer) swaption is obtained as a linear combination of
prices of puts on ZC
■ The formula giving the price of a ZC call in HW1 is deduced from the price
of ZC put in Vasicek
● This last price is easily obtained by making a change of measure, passing to
the forward measure (standard methodology), and using the Gaussian
distribution of rates in that model
70
Remarks:
● A potential numerical difficulty in this formula is to find (quickly) the
number ! ∗ , given by an implicit equation and not explicitly
● This can be done easily using the Newton-Raphson algorithm
scheme requiring an initial value as departure point (a “seed” !# ), which has
Ó Iterative
to be “well” chosen in order to get quick convergence to the “right” solution, that is, in
our case, to a value that has typically the size of an interest rate
● In practice choosing !#∗ = 0 , whatever the value of the parameters,

generally works in many practical cases…
● Remark also that the formula looks like the Black-Scholes formula as a
swaption can be seen as an option on a coupon bond, and as bond prices
are log-normal in this model 71
§ Illustration: calibration at mid 2015 (unicurve setting) on swaptions

prices (108 swaptions, maturities and expiries from 1 to 20)
§ Rem: The volatility parameter ! was constraint to 0.70%, in order to be
consistent with the historical estimation of Vasicek model shown above
(see also later). We found " = 0.83%
6 10 10
4
5 5
2
0 0 0
0 10 20 10 20 30 20 30 40
10 15 15
10 10
5
5 5
0 0 0
30 40 50 40 50 60 60 70 80
15 15 15
10 10 10
5 5 5
0 0 0
70 80 90 80 90 100 90 100 110
72
Hull-White model: Calibration of the real world dynamics
■ When using the model also for risk management purposes, as a

modeller, one has several ways to address the problem:
■ Method 1: consistent modelling real world – risk neutral
● Same theoretical model, with consistent calibration
● Theoretically sound methodology, in which a joint model, with a coherent
set of parameters, is considered
● Parameters of the risk neutral dynamics are estimated (in order to be in
line with the market) and e.g. the price of risk is then estimated based on
historical data
● Different types of price of risk can be considered in order to better fit the
data
● Another methodology consists to estimate a joint model (with an explicit
modelling of the price of risk) on histories of option prices and rates
Ó Then the risk neutral dynamics is far to be perfect, one might under- or over-estimate
the embedded options contained in the insurance contracts for instance
73

■ Method 2: partially consistent modelling real world – risk neutral
● Same theoretical model (same equation for the dynamics), but non
consistent parameters
● Non theoretically sound, but actually two models are constructed to
address two problems…
● Parameters of both dynamics are estimated separately (on histories and
on option prices respectively), without keeping consistency between both
● In particular, the volatility parameters (and in e.g. Hull-White, the mean
reversion speed) will be different in general
● This methodology is not theoretically sound, but each “sub-model” will in
practice address different questions
● The price of risk is not modelled explicitly (no need to be consistent)
74

■ Method 3: non consistent modelling real world – risk neutral
● Use of different models to address the risk neutral and real world
dynamics
● This methodology allows to better focus on the requirements of the
different purposes for which an IR model is developed: being “good” in the
tail, reflecting histories of interest rates, reflecting expectations of the
management, and to be in line with the market
Ó In general there is incompatibility between all these constraints
■ In such a case, using Hull-White model for real world simulations might
be questionable…
● Since the only purpose of adding a time-dependent mean reversion target
is to reflect the initial yield curve within the risk neutral dynamics… should
we really work within HW rather than Vasicek or another econometric
model in that case?
■ See dedicated section on the topic: price of risk modelling 75
Hull-White model: Calibration
§ Remark that we need also a pricing model (i.e. that can be specified under
a risk neutral measure) within a risk management study in insurance:
§ For market consistent valuation of liabilities (and potentially of some assets)
§ When using some tools like “replicating portfolios” or least square MC
§ In that case, replicating portfolios will generally be calibrated using a model specified
under the risk neutral measure – See specific section
§ BUT we might also need the risk neutral dynamics to simulate within a real
world simulation the future zero-coupons prices if we decide to work with a
continuous time model for the real world projections
§ In a short rate model like HW 1 factor, only the short rate is simulated in practice
§ The other rates, corresponding to other maturities, are deduced from the short rate,
applying the available analytical formula on slide 50, which is based on model
parameters of the risk neutral dynamics
76
Hull-White model: trinomial tree
§ In the framework of early exercisable options (Bermudan, American)

§ See [BM] pg 78
§ This can be generalised for G2++, but also other models like Black-
Karasinski or CIR++, CIR2++
§ Remark that 2 dimensional trinomial trees are non intuitive and much
more difficult to manage than 1 dimensional trees
77
Hull-White model: Summary of model properties
§ Short rate model, of the HJM § One-factor model

family ● Perfect correlation between rates of
different maturities
§ Mean reverting model, with
time-dependent mean-reversion § Explicit formulae for ZC prices
target and ZC options
● Allowing for perfect fit of initial yield ● Useful for practical applications and
curve (arbitrage-free condition) model calibration
§ Affine model: § Perfect calibration on the initial

● Rates of all maturities are linear yield curve, partial on
(affine) functions of the short rate swaptions prices
§ Gaussian model: § Possibility to construct a
● Rates of all maturities are Gaussian, trinomial tree for Bermudian or
Gaussian tails American options
● Possibility to get negative rates
2018-2019 78
Agenda
■ Notations and definitions
● Vasicek
● CIR
● CIR++
● CIR2++
79
Hull-White 2 factors model
§ 2-factors Hull-White model

~r ]dt + s dW (t )
æ drt = [q (t ) + u (t ) - a
ç t 1 1
ç du = -b~u (t )dt + s dW (t )
è t 2 2
§ The second factor u(t) appears as a stochastic mean reversion target

! " #$ "
(more precisely &
%
)
§ Gaussian model, allowing for negative rates, perfect calibration on the

initial yield curve (risk neutral dynamics)…
§ à Same properties as HW 1-factor, except that we have the possibility to
have non perfectly correlated movements of rates of different maturities
§ An equivalent formulation of this model is the so-called G2++ model
80
G2++ model
§ “Gaussian 2-factors ++ model”
§ Generalisation of the G2 model, i.e. the 2-factors Vasicek
§ G2++: Short rate dynamics under the risk neutral measure:

r (t ) = x(t ) + y (t ) + j (t ), r (0) = r0
dx (t ) = -ax (t )dt + sdW1 (t ), x(0) = 0
dy (t ) = -by (t )dt + hdW2 (t ), y (0) = 0
where (W1,W2) is a 2-dimensional Brownian motion with instantaneous

correlation ! ∈ [−%, %], i.e.:
()** ΔW- , ΔW. = 0
where a,b,σ,η are positive constants, and where φ(t) is a deterministic
function of time, with φ(0)=r(0) (the initial short rate).
81
G2++ model: Calibration on the initial yield curve
■ As in Hull-White, the deterministic function ! is chosen such that the

model and market initial yield curves coincide
s² h²
j (t ) = f (0, t ) +
M
(1 - exp(-at ))² + (1 - exp(-bt ))²
2a ² 2b²
sh
+r (1 - exp(-at ))(1 - exp(-bt ))
ab
82
G2++ model – Short rate distribution
■ As each factor follows a simple OU process, an analytical expression for

the short rate can be obtained (s<t):
!" = $ % + ' % + ( %

"
= $ * + ,-(",/) + y * + ,2(",/) + 3 4 + ,- ",5 678 (9)
/
"
+ : 4 + ,2 ",5 67; (9) + ((%)
/
■ Given !< , the short rate at t, !" , is hence a random variable normally
distributed with (conditional) moments:
= !" ℱ/ = $ * + ,- ",/ + ' * + ,2 ",/
+ ((%)
83
G2++ model – Link with the Hull White 2-factors model
§ Comparison with the 2-factors § Equivalence between the two

Hull-White model models
● In G2++, the calibration of the ● If we make the following change of
deterministic function ! " on the parameters, we see that both
initial yield curve does not require models are equivalent:
the computation of the first derivative
of the instantaneous forward rate Ó #$ = #
Ó& '=&
● G2++ is more frequently used in Ó () = ( * + ,* + 2.,(
interest rates options pricing than Ó (* = , # − &
HW2 Ó 0 " =
12(4)
+ #!(")
Ó Still used in a multi-curve environment 14
● Different interpretation of the factors

in G2++ than in HW2
Ó HW2 might be more intuitive (?)
2018-2019 84
G2++ model – Projection of future yield curves
§ Price of a ZC bond in the future (at future instant t, for a ZC bond of maturity T>t):
P M (0, T ) ì1
PZC (t , T ) = M expí [V (t , T ) - V (0, T ) + V (0, t )]
P (0, t ) î2
1 - exp(- a (T - t )) 1 - exp(-b(T - t )) ü
- x(t ) - y (t )ý
a b þ
§ Where x(t) and y(t) are the projected values of the two factors of the model
§ Where a, b, … are the model parameters under the risk neutral measure, and V(t,T) is defined by:
85
G2++ model – Projection of future yield curves
§ We need both risk-neutral and real world dynamics in order to project in

the future the zero-coupons prices for a risk management purpose
§ ZC prices are related to the factors x(t), y(t) through a relation involving the risk neutral
measure, and hence the risk neutral parameters
§ In a short rate model like G2++, only the two factors x(t) and y(t)) are simulated following
a discretization scheme (e.g. Euler or exact formulation or other). Other rates,
corresponding to other maturities, are deduced from the factors and the model
parameters thanks to that formula
§ At each future point, the entire yield curve is reconstructed from the simulated factors
x(t) and y(t), using that formula. The parameters in it are risk neutral parameters.
§ Time horizon is typically 1 or 5 years
§ In theory, real world dynamics parameters are identical to the risk

neutral parameters except the presence of a drift
§ Finding a real world calibration of the model compatible with the risk neutral
dynamics is not evident however in practice (same comment as for HW)
86
G2++ model – Calibration (risk neutral dynamics)
§ First step: calibration of the deterministic function ! " on the initial

yield curve:
s² h²
j (t ) = f M (0, t ) + (1 - exp(- at ))² + (1 - exp(-bt ))²
2a ² 2b ²
sh
+r (1 - exp(- at ))(1 - exp(-bt ))
ab
where fM(0,t) is the market instantaneous forward curve at time 0
§ Second step: calibration of the remaining parameters on a set of interest

rates options quoted in the market
§ On a set of European swaptions quoted in the market, or on a set of quoted caps,
depending on the problem
§ In general both calibrations (swaptions versus caps) do not provide the same results in
terms of resulting model properties, in particular a different correlation #
87
G2++ model – Calibration (risk neutral dynamics)
§ In practice
§ We first impose that the deterministic function ! " follows the adequate
analytical expression (in function of the other parameters and of the initial yield
curve)
§ Minimization of the sum of squared differences between market and model prices
of a set of swaptions M
Min
µs r
å
a ,b , , ,
(Swpt G 2+ +
i - Swpt i )
market 2
i =1
§ à need for an analytical expression for the price of a European swaption in the
model, and need for an optimization process
§ Remark that within these “model prices” the already calibrated function ! "
appears (if needed)
88
G2++: Price of a European swaption (1/5)
§ Let us consider a European swaption of strike K, maturity T = t0 giving the

right for the buyer to enter at t0 in a plain vanilla swap with payment instants
{t1,…,tn}, t1>T, in which the buyer will:
§ pay (resp. receive) fixed interest cash-flows and
§ receive (resp. pay) floating interest cash-flows (fixed at the beginning of each period,
with the hypothesis that fixed leg frequency = floating leg frequency)
§ We denote by τi the year fraction from ti-1 to ti and we set:
ci =K τi for i=1,…,n-1
and
cn =1+K τn
89
§ The value of the swaption at t=0 is given by:

(See [Brigo-Mercurio])
Like in HW1,
looks like a Black-
Scholes formula due
to log-normal
coupon bonds
Jamshidian
decomposition is
once again used in
order to get this
formula
90
Where:
and where in the expression of h(x) above, y(x) is the unique solution of:
91
Where the functions A(t,T) and B(z,t,T) are defined by:
&' (0, $) 1
! ", $ = ' +,- 0 ", $ − 0 0, $ + 0(0, ")
& (0, ") 2
1 − +,-(−4 $ − " )
3 4, ", $ =
4
And where the function V(t,T) is given by :
Volatility of P(t,T)
92
■ The implementation “challenge” in this formula is due to solving the

equation in y(x):
for each value of x involved in the discretization of the integral:
■ This solution can be obtained e.g. by Newton-Raphson method, with

seed !" = " (no explosion of the solution with this value in many
practical cases)
93
G2++ model – Probability of negative rates
§ An important feature of G2++ is the possibility to generate (deep) negative rates

§ The probability to get negative rates (or rates below a given level) can be easily explicitly
calculated thanks to the Gaussian distribution of rates:
æ µ (t ) ö
P (r (t ) < 0) = Fçç - r ÷÷, where :
è s r (t ) ø
s2 h2 shr
µ r (t ) = f (0, t ) +
M
2
[1 - exp(- at )] 2
+ 2
[1 - exp (- bt )]2
+ [1 - exp(- at )][1 - exp(- bt )]
2a 2b ab
s2 h2 2shr
s (t ) =
2
r [1 - exp(- 2at )] + [1 - exp (- 2bt )] + [1 - exp(- (a + b)t )]
2a 2
2b 2
a+b
§ (same reasoning as in the HW1 case: depart from the distribution of r(t))
§ Currently, deep negative rates are obtained due to the low level of rates in many markets
§ Negative rates are not an issue, but they can become deeply negative, and lead to non
realistic scenarios, which might be seen as an issue in real world simulations
94
Agenda
● CIR
● CIR++
● CIR2++
■ Monte Carlo simulations
● Application to IR modelling: econometric model
95
CIR model
■ Cox-Ingersoll-Ross (CIR):
!" # = % & − " # !# + ) "(#)!,-
■ Properties:
● Positive rates, non central chi-squared distributed
● Mean reverting rates
● Small number of parameters
● Relatively good tractability: analytic expressions for :
Ó moments of the short rate,
Ó ZC prices (by solving the PDE for the ZC price, leading to a Ricatti ODE)
Ó Prices of options on ZC bonds
Ó Options on coupon bonds (and hence for swaptions prices, Jamshidian decomposition
still works)
96
CIR model
■ Cox-Ingersoll-Ross (CIR):
!" # = % & − " # !# + ) "(#)!,-
■ Drawbacks
● Only one factor. Hence perfect correlation between rates of different
maturities
● No analytic expression for the solution of the SDE itself (although the
distribution of r(t) is known)
● No perfect calibration on the initial yield curve (risk neutral dynamics)
àSame type of extension as for Vasicek: CIR++ model
■ Remark:
● Since it leads to positive and non « exploding » rates (thanks to mean
reversion), it appears as a natural choice for modelling the (square) volatility
process in stochastic volatility models for equity or FX (e.g. Heston model)
97
CIR++ model
■ CIR model:
!" # = % & − " # !# + ) "(#)!,-
à Extension of the model compatible with the market initial yield curve:
" # = / # + 0 #
!/ # = % & − / # !# + ) / # 1-2
/ 0 = /4
where 56 , 8, 9, : are positive constants and ; < is determinsitic

■ The short rate is the sum of ; < and of a CIR process with mean
reversion target 9
à the mean reversion target of the short rate is & + 0 #
■ Actually, 0 # plays the same role as function = # in the equivalent
formulation of HW1 model
■ One can see that this allows a perfect calibration on the initial yield curve
98
CIR++ model – choice of the deterministic mean reversion target
■ The deterministic function !(#) is determined as in the second

(equivalent) formulation of Hull-White model:
% & = ( ) 0, & − ( -./ 0, &

where:
● ( ) (0, &) is the market instantaneous forward rate curve at 0
● ( -./ (0, &) is the instantaneous forward rate curve at 0 of the CIR model
driving the dynamics of the factor 0(&), whose analytical expression is
easily obtained from the price 1 0, & of a ZC bond in CIR model:
where ℎ = 7 8 + 2; 8
99
■ By using the same reasoning as in the case of Hull-White 1 factor, we

get by this choice of ! " that # 0, & = #()*+,- (0, &)
■ Note that this construction can be generalized to any short rate model
100
■ Once again, the instantaneous forward curve of the market at initial

instant t=0 (!" ($, &)) can be directly obtained by differentiating
(numerically or analytically from an parametrical fit) the initial spot yield
curve
)
. ln 1(0, +)
( 0, + = −
.+
■ Remark
● The initial value of x(t), x0, is a parameter of the model calibrated on
market data, like the 3 other parameters 2, 3, 4.
● For any value of x0, since 5(+) will be calibrated on the initial yield curve,
the initial value of r(t) (i.e. r(0)) will always be equal to the market short
rate at calibration date (à this step is “automatically” performed)
101
. CIR++ model – moments of the short rate
■ From the analytical expressions for the moments of the short rate in CIR
model, we can get analytical expression for the moments within CIR++
■ We see also that

lim '[) * ] = . + lim 0(*)
$→& $→&
102
CIR++ model – price of a ZC bond
■ Analytical formula for the price of a ZC bond:
! ", $ = &̅ ", $ ()*(−- ", $ . " )

where:
à Affine model like CIR (and HW, Vasicek, G2++)
103
CIR++ model – price of a swaption
Price of a receiver swaption, with strike X, maturity T, and nominal N, on a swap

with instants !" , … , !% , where !" > ':
( ∑%+," *+ -./011 2, 3, 2 4 , 54
where 789:;;(!, ', =, >) is given by:
with:
and where @+ = B(!+ , ', C !+ = C∗ ), where C∗ is solution of:

J ', !+ KLM(−8 ', !+ C∗ ) = "
∑%+," *+ I
and *+ = @. !+ − !+P" QRC + = ", … , % − " , *% = " + @. (!% − !%P" )
104
■ Comments:
● Remark that this formula is again obtained by using Jamshidian
decomposition
● Now, as rates are not normal anymore but chi-squared distributed, the
standard normal is replaced by the non central chi-square distribution in the
Black-Scholes like formula
● Remark also that the difference appearing in the formula is due to the
payoff, containg the . " function
105
■ Comments:
● In the formula above, !" #, %, & denotes the CDF at ' of the non central chi-
squared distribution with ) DoF and noncentrality parameter *:
● It is the distribution obtained when summing the square of k reduced (but non
centered) independent normal variables +, of mean -, and variance 1
0
. +,/
,12
● Parameter * corresponds in this construction to : ∑0,12 -,/
● The CDF is given by:
,
< *
8
4 ' = 6 7/ . 2 4>A (')
:! ?@AB
,1=
where 4>A (') is the CDF of a central chi-square distribution with ) + 2: DoF
?@AB
● In practice, computing this CDF might be time consuming, and different
approximations have been established in order to compute this CDF
106
■ Comments
● Now, accuracy of the different approximations depends on ! and " (there is
no approximation that works in all the cases)
● In the current case, values of ! can takes values in a large range (typically
between 0.00001 and 1000) during calibration … !
● This means that the approximation used by the code (external vendor or
not) should be able to address different ranges of values for that parameter
107
■ Calibration is not always straightforward. Sensitivity analysis might help
Impact of sigma Impact of kappa

7 7
6 6
0.12569
0.14569
0.10569
0.085692
5 5
0.065692 0.023745
0.12375
4 4
0.22375
3 3
0.32375
2 2 0.42375
1 1
0 0
4 6 8 10 12 14 16 18 20 4 6 8 10 12 14 16 18 20
108
■ Calibration is not always straightforward. Sensitivity analysis might help
Impact of theta Impact of x0

7 10
0.6
0.045
0.5 9
6
0.4 0.035
8
5 0.3 0.025
7
0.2
6 0.015
4
5
0.005
3
4
2 3
2
1
1
0 0
4 6 8 10 12 14 16 18 20 4 6 8 10 12 14 16 18 20
109
CIR++ model – Risk-neutral calibration
■ Example (on Mid 2015 data)

● Choosing high ! typically leads to more negative "($)
6 8 10
6
4
4 5
2
2
0 0 0
-0.01 0 10 20 30 0 10 20 30 0 10 20 3
PhiCIR
-0.02 10 15 15
-0.03 10 10
5
-0.04
5 5
-0.05
0 0 0
5 10 15 20 25 0 10 20 30 0 10 20 3
-0.06
15 15 15
-0.07
0 10 20 30 40 50 60
10 10 10
5 5 5
0 0 0
10 20 30 40 10 20 30 40 20 30 40 5
110
CIR++ model – Risk-neutral calibration
6 8 10
6
4
4 5
2
2
0 0 0
0 10 20 30 0 10 20 30 0 10 20 30
10 15 15
10 10
5
5 5
0 0 0
5 10 15 20 25 0 10 20 30 0 10 20 30
15 15 15
10 10 10
5 5 5
0 0 0
10 20 30 40 10 20 30 40 20 30 40 50
111
CIR++ model – main properties
§ Short rate at instant t : non § Mean reversion behaviour

central chi-square distribution, ● With time dependent target: , +
corrected by phi(t) . (
● Explicit formulae for the mean and
§ 4 parameters (/* , ,, 1, 2)
variance of r(t)
● instead of 2 in Hull-White or Vasicek
● The factor x(t) is always positive
models for instance
(and does not touch 0) if the Feller
condition is satisfied: 2"# > % &
§ In consequence, all rates are § Affine model
● ZC rates are linear functions of the
strictly positive, unless short rate, with coefficients
' ( < * for some t depending on the maturity of the rate
● Negative rates can be produced,
when calibrating the model on an
initial negative yield curve – this is
important in period of negative rates
2018-2019 112
CIR++ model – main properties
Advantages Drawbacks
§ Analytical formulae § One factor model
● for the prices of ZC bonds and ZC ● perfect correlation of rates of
rates different maturities
● à “easy” Monte Carlo simulation of ● à Use of CIR2++ or CIR3++
the whole yield curve ● These models are however much
less easy to calibrate, due to the
§ Perfect calibration on the initial high number of parameters, and the
yield curve loss of analytical tractability (no
analytical formula for swaptions
§ Easy calibration on swaptions anymore)
● thanks to the available analytical
formula for the price of a swaption
2018-2019 113
CIR++ vs G2++ : illustration
■ Simulations of the short rate in a G2++ model (left) and CIR++ (right)
after calibration on exactly the same market data:
114
CIR++ vs G2++ : illustration
■ Similar comparison (other calibration set)

Short rate comparison - CIR++ vs G2++
0.25
0.995 CIR++
0.005 CIR++
0.2
Mean CIR++
0.995 G2++
0.15 0.005 G2++
Mean G2++
0.1
0.05
-0.05
-0.1
0 50 100 150 200 250 300 350 400 115
Agenda
● Vasicek
● CIR
● CIR++
● CIR2++
■ Monte Carlo simulations
116
CIR2/CIR2++: the 2 factors version
■ In CIR2, the short rate is assumed equal to ! " + $ " , where

! " , $(") are two processes following each a CIR model:
() * = ,- .- − ) * (* + 0- ) * (1- * , ) 0 = )3
(4 * = ,5 .5 − 4 * (* + 05 4 * (15 * , 4 0 = 43
where 67 , 68 are independent BM
■ One can show that the price of a ZC bond is given by the product of
prices of ZC bonds in each underlying CIR model, thanks to the
independence assumption of BM:
9:;<5 *, = = 9:;< (*, =; ) * , ?- )9:;< (*, =; 4 * , ?5 )
where @7 = (A7 , B7 , C7 , !D ) and @8 = (A8 , B8 , C8 , $D )
■ From this fact, we can deduce that ZC rates under CIR2 are just obtained
as sums of the corresponding rates under CIR
117
■ In CIR2, prices of ZC calls can still be obtained by an analytical formula

(obtained by Chen-Scott) involving the valuation of the CDF of non
central chi-square distributions
■ Remark that the independence assumption on BM is mainly required in

order to keep (some!) analytical tractability
118
■ In CIR2++, the short rate is assumed equal to ! " + $ " + %("),

where !(") is a deterministic function, and $ " , %(") are two
processes following each a CIR model (under a risk neutral probability):
)* + = -. /. − * + )+ + 1. * + )2. + , * 0 = *4
)5 + = -6 /6 − 5 + )+ + 16 5 + )26 + , 5 0 = 54
where 78 , 79 are independent BM
■ The deterministic function ! is given following the same methodology
as for Hull-White, G2++ or CIR++:
: + = ; < 0, + − ; =>? 0, +; *4 , A. − ; =>? 0, +; 54 , A6
■ Assuming this allows to reproduce the market yield curve at t=0
■ An analytical formula for ZC bonds is obtained in the same way as for
G2++, in which ZC bond prices under CIR appear…
● The methodology followed to derive the ZC prices from ZC prices in CIR is
identical as for G2++, CIR++ 119
■ Analytic formulae for ZC bonds options are deduced from the ones
existing for CIR++
■ For practical purpose, this allows to price caps and floors by analytic
formulae
■ Unfortunately, Jamshidian decomposition does not work anymore for
coupon bonds options, and hence there is no analytic formula for
swaptions
● Recall that a swaption can be seen as an option on a coupon bond (put or
call, depending wether the swaption is payer or receiver)
● Alternative methods can be however used to price swaptions, but in order
to calibrate the models, these are less practical as much time consuming
● These methods encompass:
Ó Monte Carlo simulation – based on a unique set of pseudo random numbers, ideally
with a reduced number of scenarios – « sufficiently representative » - to speed up
computation
Ó Use of a tree combining the two trinomial trees of the underlying CIR processes
120
Generalization of this construction
■ Different extensions of first generation models have been considered,

leading to models whose risk neutral dynamics is able to reproduce
market prices of ZC bonds
● Initial market yield curve coincide with initial model yield curve
■ Vasicek à HW1
● HW1 : adaptation of Vasicek in order to get a model compatible with the
initial yield curve
■ G2 (2 factors Vasicek) à G2++
● G2++: adaptation of the 2-factors Vasicek (G2).
● The G2++ is equivalent to the 2-factors Hull-White model
■ CIR à CIR++
■ CIR2 à CIR2++
■ This construction can be generalized to any short rate model
121
■ Let us consider a stochastic process xα(t) whose dynamics is given

under the risk neutral measure by:
dxa (t ) = µ ( xa (t );a )dt + s ( xa (t );a )dW (t )
where α=(α1,…, αn) is a vector of parameters and σ, µ are « sufficiently

smooth » functions
■ Let us assume first that the process xα(t) describes the evolution of the
short rate under the risk neutral measure. This will be considered as the
reference model
● Examples: Vasicek, CIR
■ The aim is to extend/modify this initial model in such a way that the yield
curve at t=0 of the new model perfectly fits the market yield curve
122
■ For that purpose, we will suppose that the short rate can be
decomposed in:
! " = $ " + &(")
for some deterministic function φ(t), and where x(t) satisfies under the risk-
neutral measure Q the reference initial process introduced before
■ Then , the parameters of this new model are : ) = ()* , … , )- ) as well

as the initial value of x(t): $.
● This initial value appears indeed as a new parameter to be chosen, if we
impose further: / 0, 1 = 23 − 53
123
General result:
■ The model introduced above can be perfectly fitted on the initial yield
curve (observed from the market) if and only if the deterministic function
φ satisfies:
! " = $% &, " − $ ) " (&, "; ,)
for any values of the parameters , = (,. , … , ,0 ) and )&
■ The reasoning used to show this result is similar to the one used for
HW1 or CIR++… (same reasoning as on slide 100 for instance)
124
Agenda
■ Monte Carlo simulations of interest rates models
125
Monte Carlo simulations
■ Example : Vasicek model

● One possibility is to use the Euler scheme:
! "#$% = ! "# + a b − ! "# "#$% − "# + + "#$% − "# ,#
This directly comes from the short rate SDE:

-!. = / 0 − ! " -" + +-1.
→ Δ!. = !.$4. − !. ≈ / 0 − ! " Δt + + Δ" 8#
● This however introduces discretization error in the projection, in addition to

the Monte Carlo error itself
§ It is more precise to use the (exact) solution of the SDE for Vasicek model
(OU process):
= − >?E@A:
9:;<= = 9:; >?@AB + C = − >?@A: +D F;
E@
126
■ Example : Hull-White model

● Once again, we have the corresponding Euler scheme:
! "#$% = ! "# + a ) "# − ! "# "#$% − "# + + "#$% − "# ,#
coming from the short rate SDE:

-!. = / ) " − ! " -" + +-0.
→ Δ!. = !.$3. − !. ≈ / ) " − ! " Δt + + Δ" 7
● Euler scheme using the equivalent formulation:

8 "#$% = 8 "# − /8 "# "#$% − "# + + "#$% − "# ,#
; >?
9 "#$% = : 0, "#$% + 1 − C DA.EFG
@A ?
@
! "#$% = 8 "#$% + 9("#$% )
● This introduces again discretization error in the projection, in addition to

Monte Carlo error itself 127
■ Example : Hull-White model

● This can be improved by departing from the equivalent formulation, and
using the exact solution of the SDE for Vasicek model just mentioned:
● The Monte Carlo simulation is then obtained as:
%-./0(-23 4567-45 )
! "#$% = ! "# '!( −* "#$% − "# +, 23
9#
< ?@
: "#$% = ; 0, "#$% + 23 @
1 − ' -34567 2
C "#$% = ! "#$% + : "#$%
where D(. ) is obtained from the initial instantaneous forward curve of the market at t=0
● There is here no discretization error (only Monte Carlo error)
128
■ Example: CIR++ Model – Euler scheme:

x(t i +1 ) = x(t i ) + k (q - x(t i ))(ti +1 - t i ) + s x(ti ) t i +1 - ti e i
● In theory, the probability to get negative rates is zero if Φ(t) >0
● If the Feller condition is satisfied, in theory x(t) will not reach 0, but
discretisation error implies in practice that 0 can be reached, and even
crossed… leading to complex numbers
Ó Due to the square root appearing when generating the next iteration
■ In order to avoid such a situation, a simple option is to use the positive
part in the square root, forcing negative values of x(t) to 0 or a small
positive number, i.e. using the following modified Euler scheme:
x(ti +1 ) = x(ti ) + k (q - x(ti ))(ti +1 - ti ) + s ( x(ti ))+ ti +1 - ti e i
if x(ti +1 ) < 0, then x(ti +1 ) = 0
● Alternative discretization schemes have been developed in the past 20
years (e.g. [Scott, 1996], [Deelstra-Delbaen 1998])
129

Stochastic - Methods - Interest Rates - 1 PDF

Uploaded by

Copyright:

Available Formats

You might also like

Stochastic - Methods - Interest Rates - 1 PDF

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Stochastic - Methods - Interest Rates - 1 PDF

Uploaded by

Copyright:

Available Formats

Agenda

Stochastic ALM models

§ Interest rates models:

■ First generation of pricing models: endogeneous short rate models

■ First generation of pricing models – Examples:

■ Second generation : exogeneous models

● Rem: these models can be considered in the more general framework of

■ Third generation of pricing models: market models

● Directly inspired from Black 76 model, but « true » models

■ Fourth generation: multicurve models

■ Fourth generation: multicurve models

■ Fourth generation: multicurve models

Source: Ridwan Nori master thesis, ULB, 2015

■ Fourth generation: Multicurve models

● In order to maintain model complexity acceptable, and in particular a

■ We mentioned here continuous time models developed for the purpose of

When choosing an IR model, different important questions must be addressed:

When choosing an IR model, different properties and questions must be

When choosing an IR model, different properties and questions must be

When choosing an IR model, different properties and questions must be

■ Can we easily perform Monte-Carlo simulations ?

■ This section recalls the main properties of the Vasicek model

■ The short rate is supposed to follow an Ornstein-Uhlenbeck (OU) process:

■ Historically, Vasicek introduces the dynamics under the real world

Deterministic trend Stochastic noise

■ Solving the OU SDE:

■ Solving the OU SDE:

§ in red: the deterministic trend (see previous slide).

§ The short rate follows hence a Gaussian distribution, with explicit

!" # = "% &'(# + * + − &'(#

§ Same type of result for the conditional distributions :

3 !" !$ = !$ %&'("&$) + + , − %&' "&$

§ One-factor model: rates of all maturities are perfectly correlated

§ Analytical formulae for prices of zero-coupons, but also European

§ Price of zero-coupon bonds and risk neutral measure:

§ Price of zero-coupon bonds and risk neutral measure:

■ Price of zero-coupon bonds and risk neutral measure:

■ Shape of the yield curve:

in which () = 123%→) ((#, %) is the “ultimate” long term rate

12 ", - = $% 2(", -)1" − 30 ", - 2(", -)14 ∗ "

12 ", - = 2 ", - ($% +:30 ", - 1" − 30 ", - 14 " ]

!"# = % & − "# !# + )!*#

!"# = % + # − "# !# + )!*#

■ We focus now on the calibration of Vasicek model

Real world dynamics calibration: Linear regression / AR1

Real world dynamics calibration: Linear regression / AR1

● This can be seen as an AR(1) model: :(#* = ;< :( + ;* + =( ,

Real world dynamics calibration: Linear regression / AR1

● This can be seen as another AR(1) model: 0123 = 45 01 + 43 + 61 ,

Real world dynamics calibration: Linear regression / AR1

Real world dynamics calibration: Linear regression / AR1

Real world dynamics calibration: Linear regression / AR1

! ", $ = & '( − "*( − $ +

● By derivating !(", $) with respect to a and b, and equalling the

and *̅ , '< are the sample means of X and Y

Real world dynamics calibration: Linear regression / AR1

EUR1M9914-Ornstein Uhlenbeck - monthly data EUR1M9914-Ornstein Uhlenbeck - daily data

min ((+$,-./0 0, 5- ; 7, 8, 9 − ;$<0/= (0, 5- ))²