Interest Rate Modelling: Autumn 2 0 0 9

A U T U M N 2 0 0 9
INTEREST RATE MODELLING
Numerical Methods in Finance (Implementing Market Models)

COMPUTATIONAL FINANCE
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©Finbarr Murphy 2007
Lecture Objectives
 Interest Rate Modelling
 Traditional Interest Rate Models

 Vasicek 77
 CIR 95
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Agenda
Page
1
Interest Rate Modelling 2
2
Traditional Term Structure Models 10
3
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3
Interest Rate Modelling

 Definition: Interest Rate
 The percentage of an amount of money that's paid

for its use over a specified time period
 Very few market instruments do not use interest rates

in their effective valuation
 Definition: The Term Structure of Interest Rates

 The term structure of interest rates is a graphic

representation of how interest rates vary with
maturity; it shows the relationship between the yield
from a financial instrument and its maturity.
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 Yields across different outstanding maturities can be
plotted to create a yield curve
 The term structure of interest rates is better known

as the yield curve.
 Yield curves come in different shapes but they always

refer to instruments of a homogeneous (the same)
nature.
 As interest rates change - or as expectations of future

interest rates change - investors will typically switch
between maturities to try to achieve capital gains (or
at least to avoid capital losses).
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 In this lecture, we are primarily concerned with how
one might model an interest rate/term structure
 In the same way that the modelling of stock price

behaviour gave us models to calculate option prices,
the ability to model the term structure of interest
rates allows us to model any number of fixed income
derivatives
 There are two basic approaches:
 See slide:
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 For the moment, we will look at modelling interest
rates using traditional term structure models
 We begin with a look at a pure discount bond
 This is denoted by
ˆ   s

P( t , s ) = Et exp − ∫ r (τ ) dτ  
  t 
 Where r(τ) is the short rate path between t and s
 And Êt is the risk neutral expectation at time = t

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 Consider a constant rate of 6% (the green line)
 The PV discount bond, in this case, can be calculated

as exp(-r(s-t))
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 But the actual value will be the expected short path
 To see this, consider the integral of the blue line,

discretised into 10 Δt steps
Δt
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 Early term structure models supposed that the entire
term structure was driven by one source of
uncertainty
 So called, 1-factor models
 This single source of uncertainty is the short rate
 We start with the Vasicek (1977) model

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Agenda
Page
1
Interest Rate Modelling 2
2
Traditional Term Structure Models 9
3
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Traditional Term Structure Models

 The Vasicek (1977) model
 The SDE representing the uncertainty in the short

rate is give by the equation
dr = α ( r − r ) dt + σdz
 Where
 r(t) is the short rate at time t
 dz is a Weiner increment
 r is the long term mean rate of r
 The volatility of the short rate is assumed to be a constant σ
 α is the rate at which r reverts to r
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 The short rate is assumed to follow the Ornstein-
Uhlenbeck process
 r, α and σ can be calculated using regression

techniques
 Under Vasicek, the discount rate is given by

− rB ( t , s )
P(t , s ) = A(t , s )e
 The equivalent continuously compounded yield is

given by
ln A(t , s ) B(t , s )
R(t , s ) = − + r
s −t s −t
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 Where
1
(
B(t , s ) = 1 − e −α ( s −t )
α
)
 And
σ
( ) ( )
2
R∞
ln A( t , s ) = 1 − e −α ( s −t ) − ( s − t ) R∞ − 3 1 − e −α ( s −t )
2
α 4α
 and
1σ 2
R∞ = lim R( t ,τ ) = r −
τ →∞ 2 α2
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 These functions can be easily coded in MatLab
 Try it!
 The spot rate volatility structure is determined by

two parameters σ and α
σ
( )
σ R t, s =
α(s − t)
(1− e −α ( s −t )
)
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 Here is the Vasicek code for the discount bond
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 Cox-Ingersoll-Ross
 The Vasicek model has two major short falls

 Interest rates can be negative in the model
 The negative correlation between interest rates and interest
rate sensitivity is ignored
 CIR (1995) introduce a model where the volatility of

the short rate increases with the square root of the
level of the rate
 This precludes negative rates
 Displays more variability in high rate environments

and visa versa
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 The CIR SDE is given by
dr = α ( r − r ) dt + σ r dz
 As with Vasicek 77, the discount rates and

continuously compounded yields are given by
− rB ( t , s )
P(t , s ) = A(t , s )e
ln A(t , s ) B(t , s )
R(t , s ) = − + r
s −t s −t
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 With φ3
 φ1e φ2 ( s −t )

A( t , s ) =  
 φ2 ( e φ1 ( s −t )
) 
− 1 + φ1 
 e φ1 ( s −t )
−1 
B( t , s ) =  
 φ2 ( e φ1 ( s −t )
)
− 1 + φ1 
 And where
φ1 = α + 2σ 2 2
α + φ1
φ2 =
2αr 2
φ3 = 2
σ
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 Here is the CIR Code
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 The CIR volatility term structure of spot rates is given
by
σ r
σ R (t , s ) = B (t , s )
s −t
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 Here is a graph of 100 random movement in the short
rate. Note the convergence to the mean
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Recommended Texts
 Required/Recommended
 Clewlow, L. and Strickland, C. (1996) Implementing derivative
models, 1st ed., John Wiley and Sons Ltd.
— Chapter 6, 7
 Additional/Useful
 Hull, J. (2005) Options, futures and other derivatives, 6th ed.,
Prentice Hall
— Chapters 4
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A U T U M N 2 0 0 9

INTEREST RATE MODELLING

Numerical Methods in Finance (Implementing Market Models)

 Traditional Interest Rate Models

Interest Rate Modelling

 The percentage of an amount of money that's paid

 Very few market instruments do not use interest rates

 Definition: The Term Structure of Interest Rates

 The term structure of interest rates is a graphic

Interest Rate Modelling

 The term structure of interest rates is better known

 Yield curves come in different shapes but they always

 As interest rates change - or as expectations of future

Interest Rate Modelling

 In the same way that the modelling of stock price

 There are two basic approaches:

Interest Rate Modelling

 We begin with a look at a pure discount bond

 Where r(τ) is the short rate path between t and s

 And Êt is the risk neutral expectation at time = t

Interest Rate Modelling

 The PV discount bond, in this case, can be calculated

Interest Rate Modelling

 To see this, consider the integral of the blue line,

Interest Rate Modelling

 So called, 1-factor models

 This single source of uncertainty is the short rate

 We start with the Vasicek (1977) model

Traditional Term Structure Models

 The SDE representing the uncertainty in the short

Traditional Term Structure Models

 r, α and σ can be calculated using regression

 Under Vasicek, the discount rate is given by

 The equivalent continuously compounded yield is

Traditional Term Structure Models

Traditional Term Structure Models

 The spot rate volatility structure is determined by

Traditional Term Structure Models

Traditional Term Structure Models

 The Vasicek model has two major short falls

 CIR (1995) introduce a model where the volatility of

 This precludes negative rates

 Displays more variability in high rate environments

Traditional Term Structure Models

 As with Vasicek 77, the discount rates and

Traditional Term Structure Models

Traditional Term Structure Models

Traditional Term Structure Models

Traditional Term Structure Models

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