Name: _______________________

Exam 3

Directions: Place all answers in a word document.

1. Consider the current term structure of discount factors 𝑇 ↦ 𝑃 (𝑡, 𝑇) for 𝑇 > 𝑡.
a. (10 pts) Consider any two discount factors in a one-factor model: 𝑃 (𝑡, 𝑇1) =
𝐴(𝑡, 𝑇1) exp{−𝐵(𝑡, 𝑇1)𝑟(𝑡)} and 𝑃 (𝑡, 𝑇2 ) = 𝐴(𝑡, 𝑇2 ) exp{−𝐵(𝑡, 𝑇2 )𝑟(𝑡)}. Prove
that the correlation between interest rates, 𝑅(𝑡, 𝑇𝑖 ) = − ln 𝑃(𝑡, 𝑇𝑖 ), is identical to 1.
b. (10 pts) Consider any two discount factors in a two-factor model: 𝑃 (𝑡, 𝑇1 ) =
𝐴(𝑡, 𝑇1) exp{−𝐵 𝑥 (𝑡, 𝑇1)𝑥 (𝑡) − 𝐵 𝑦 (𝑡, 𝑇1 )𝑦(𝑡)} and 𝑃 (𝑡, 𝑇2 ) =
𝐴(𝑡, 𝑇2 ) exp{−𝐵 𝑥 (𝑡, 𝑇2 )𝑥(𝑡) − 𝐵 𝑦 (𝑡, 𝑇2 )𝑦(𝑡)}. Prove that the correlation between
interest rates, 𝑅(𝑡, 𝑇𝑖 ) = − ln 𝑃 (𝑡, 𝑇𝑖 ), is not identical to 1.

2. Consider the following two factor model:

𝑟 (𝑡 ) = 𝑥 (𝑡 ) + 𝑦 (𝑡 ), 𝑟(0) = 𝑟0 ,
𝑑𝑥 (𝑡) = −𝑎𝑥 (𝑡)𝑑𝑡 + 𝜎𝑑𝑊1 (𝑡), 𝑥 (0) = 𝑥0 ,
𝑑𝑦(𝑡) = −𝑏𝑦(𝑡)𝑑𝑡 + 𝜂𝑑𝑊2 (𝑡), 𝑦(0) = 𝑦0 ,
where 𝑊1 and 𝑊2 are standard Brownian motions with a correlation coefficient 𝜌.
a. (10 pts) What is the conditional expectation 𝔼{𝑟(𝑡)|ℱ𝑠 }?
b. (10 pts) What is the conditional variance 𝕍{𝑟(𝑡)|ℱ𝑠 }
c. (10 pts) What is the distribution of 𝑟(𝑡)|ℱ𝑠 ?
d. (10 pts) Derive the zero-coupon bond price for this model.

3. (40 pts) Use python to construct a recombining trinomial tree for the Vasicek model:
𝑑𝑟(𝑡) = 𝑎[𝜃 − 𝑟(𝑡)]𝑑𝑡 + 𝜎𝑑𝑊 (𝑡),
2
where at each step the conditional mean 𝑀𝑖,𝑗 and conditional variance 𝑉𝑖,𝑗 match those implied by
the Vasicek model. For the values of 𝑎, 𝜃, and 𝜎, use the values that are attained from calibrating
the Vasicek model to the most recent year of daily observations on the 3-month constant maturity
treasury rate.