Modelling Interest Rates: Autumn 2 0 0 9

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

COMPUTATIONAL FINANCE
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©Finbarr Murphy 2007
Lecture Objectives
 Two Factor Models
 Fong and Vasicek (1992)
 Longstaff and Schwartz (1992)
 Term Structure Consistent Models

 Ho & Lee 1986
 Hull & White 1993
 Black and and Karasinski (1991)
 Heath, Jarrow and Morton (HJM) (1992)
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Agenda
Page
1
Two Factor Models 2
2
Term Structure Consistent Models 10
3
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Two Factor Models

 To recap at this time:
 There are two areas of interest rate modelling

 Traditional Term structure modelling and
 So far we have looked at two traditional models:

 Vasicek (1977) and
 CIR (1985)
 These 1-factor models are easily programmable

but can only generate curves that are
monotonically increasing, monotonically
decreasing or slightly humped
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Two Factor Models

 More realistic term structures involve those with
two or more sources of uncertainty
 Fong and Vasicek (1992) proposed a 2-factor

model of the term structure of interest rates
 The two sources of uncertainty are

 The short rate r and
 The variance of the short rate v
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Two Factor Models

 These two process are driven by the PDE’s
dr = [α ( r − r ) ] dt + v dz1
dv = [ γ ( v − r ) ] dt + ξ v dz 2
 And
dz1dz 2 = ρdt
 The solution for the discount bond price and yield

are programmable with a degree of complexity
although some analytical shortcuts are available
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Two Factor Models

 Aside from the relative difficulty of programming
the VF92 model, the parameters of the PDE must
also be estimated through some complex
regression testing
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Two Factor Models

 Longstaff and Schwartz (1992) also developed a 2-
factor model
dx = ( γ − δx ) dt + x dz1
dy = (η − θy ) dt + y dz 2
 With the short rate defined by
r = αx + β y
 And the volatility is given by
v =α x+β y
2 2
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Two Factor Models

 The LS92 2-factor model is slightly more easily to
programme
 Both VF92 and LS92 provide tractable solutions

for the term structure
 The resultant curves exhibit many of the

characteristics of a “real-world” curve
 They provide a term-consistent paradigm for

pricing bonds and bond derivatives

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Two Factor Models

 The problem with traditional term structure of
interest rate models is that they do not correctly
price many currently traded bonds
 I.e The curve is likely to fit with some traded

bonds but not will all traded bonds
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Agenda
Page
1
Two Factor Models 2
2
Term Structure Consistent Models 10
3
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11
Term Structure Consistent Models

 To recap at this time:
 There are two areas of interest rate modelling

 Traditional Term structure modelling and
 So far we have looked at two traditional models:

 Vasicek (1977) and
 CIR (1985)
 These 1-factor models are easily programmable

but can only generate curves that are
monotonically increasing, monotonically
decreasing or slightly humped
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12

 Ho & Lee 1986 were the first to develop a model
consistent with the initial yield curve
 The short rate is given by the process
dr = θ (t )dt + σdz
 Θ(t), the drift function, represents the slope of
the initial forward rate curve
 And the volatility of the short rate process

∂f (0, t )
θ (t ) = +σ t
2
∂t
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 The partial derivative denotes the slope of the
initial forward curve at maturity t
 The drift function, Θ(t) allows us to use the

observed market bond prices to “fit” the model
 we will look at this in more details later
 The HL86 model is a

 Single factor
 No mean reversion
 Negative interest rates are possible
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 The drift function Θ(t) does not depend on the
short rate
 The volatility structure for spot and forward rates

is determined by the constant σ
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 The analytical results relate future bond prices to
the current term structure
 The future bond prices are denoted by P(T,s)

where T >= t
 On a time-line this looks like:

t=0 t=t t=T t=s
 Giving
P ( T , s ) = A( T , s ) e − B (T , s ) r (T )
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 Where
B( T , s ) = ( s − T )
 and
P( t , s ) ∂ ln P( t , T )
ln A(T , s ) = ln − B( T , s )
P( t , T ) ∂T
1 2
− σ ( T − t ) B( T , s )
2
2
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 Time to look at a simple example
 Let’s assume that the current term structure is a

flat 5% continuously compounded rate
 Short rate volatility σ = 1%
 We also assume that the short rate in one year,

r(T) = r(1) = 5%
 What is the price of a bond in one year with a 4

year maturity at that time? I.e. it currently has 5
years to maturity
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P(0,5) = e-0.05*5 = 0.7788
P(0,1) = e-0.05*1 = 0.9512
 Therefore
P(1,5) = A(1,5)e-B(1,5)r(1)
 The A(·, ·) term has a partial derivative that can

be approximated using the slope. I.e.
∂ ln P( t , T ) ln P( t , T + ∆t ) − ln P( t , T − ∆t )
≈
∂T 2∆t
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 Letting Δt = 0.1 year, this gives
P(1,5) = 0.8181
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 Now we can calibrate the HL86 model to existing
option data
 Supposing we have a series of options on discount

bonds
 The price of these options is denoted by
marketi where i=1,…,M

 One way to calibrate our model is to minimise the

following with respect to σ
M
 modeli (σ ) − market i 
∑ 
i =1  market i


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 Where modeli(σ)is the price produced using σ
 We will need to search through a range of σ’s
 If M>1, we can only find σ that best fits the

solution
 Options on discount bonds are uncommon but we

can use other interest rate derivatives such as
cap and floors
 These can be thought of as a series of discount

bond options
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 Hull and White 1993
 The SDE for this model is given by
dr = [θ ( t ) − αr ] dt + σdz
 This model can be thought of as HL86 with mean

reversion
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 Hull and White Extensions
 One extension to HW93 model is to allow the

reversion rate to be time dependent
dr = [θ ( t ) − α ( t ) r ] dt + σdz
 This automatically introduces time dependent

volatility σ(t,s) which is the volatility of a yield

with maturity s as seen at time t
 This can be fitted to observed volatility term

structures
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 Other 1-factor models
 Black, Derman and Toy (BDT) 1990
 σ ' (t ) 
d ln r (t ) = θ ( t ) + ln r ( t )  dt + σ ( t ) dz
 σ (t ) 
 Θ(t) and σ(t) are chosen to match current term

structures
 But this must be done numerically

 Not very tractable
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 Black and and Karasinski (1991)
d ln r = [θ ( t ) + α (t ) ln r ] dt + σ ( t ) dz
 Numerically implemented using trinomial trees
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 Hull and White (1994b)
 2-factor model
dr = [θ ( t ) + u − αr ] dt + σ 1dz1
du = −budt + σ 2 dz 2
 u is a mean reversion level with a random element

 dz1 and dz2 are correlated through ρ

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 The HW94b model has the advantage of being
partially analytical
 The future discount bond price is given as
P( T , s ) = A( T , s ) e − r ( T ) B ( T , s ) −u ( T ) C ( T , s )
 The extra stochastic factor allows for a much

richer potential for yield curve shapes and

possible volatility term structures
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 Heath, Jarrow and Morton (HJM) (1992)
 This is a multi-factor model
 It basically states that the drifts of individual

yields are a function of that yields volatility and
of the correlation between the volatilities across
the yields
 The Heath-Jarrow-Morton (HJM) model is one of

the most widely used models for pricing interest

rate derivatives
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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 7
 Additional/Useful
 Hull, J. (2005) Options, futures and other derivatives, 6th ed.,
Prentice Hall
— Chapters 28
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A U T U M N 2 0 0 9

MODELLING INTEREST RATES

Numerical Methods in Finance (Implementing Market Models)

 Term Structure Consistent Models

Two Factor Models

 There are two areas of interest rate modelling

 So far we have looked at two traditional models:

 These 1-factor models are easily programmable

Two Factor Models

 Fong and Vasicek (1992) proposed a 2-factor

 The two sources of uncertainty are

Two Factor Models

 The solution for the discount bond price and yield

Two Factor Models

Two Factor Models

 And the volatility is given by

Two Factor Models

 Both VF92 and LS92 provide tractable solutions

 The resultant curves exhibit many of the

 They provide a term-consistent paradigm for

pricing bonds and bond derivatives

Two Factor Models

 I.e The curve is likely to fit with some traded

Term Structure Consistent Models

 There are two areas of interest rate modelling

 So far we have looked at two traditional models:

 These 1-factor models are easily programmable

Term Structure Consistent Models

 The short rate is given by the process

 And the volatility of the short rate process

Term Structure Consistent Models

 The drift function, Θ(t) allows us to use the

 The HL86 model is a

Term Structure Consistent Models

 The volatility structure for spot and forward rates

Term Structure Consistent Models

 The future bond prices are denoted by P(T,s)

 On a time-line this looks like:

t=0 t=t t=T t=s

Term Structure Consistent Models

Term Structure Consistent Models

 Let’s assume that the current term structure is a

 Short rate volatility σ = 1%

 We also assume that the short rate in one year,

 What is the price of a bond in one year with a 4

Term Structure Consistent Models

P(0,1) = e-0.05*1 = 0.9512

 The A(·, ·) term has a partial derivative that can

Term Structure Consistent Models

Term Structure Consistent Models

 Supposing we have a series of options on discount

 The price of these options is denoted by

marketi where i=1,…,M

 One way to calibrate our model is to minimise the

Term Structure Consistent Models

 We will need to search through a range of σ’s

 If M>1, we can only find σ that best fits the

 Options on discount bonds are uncommon but we

cap and floors

 These can be thought of as a series of discount

Term Structure Consistent Models

 The SDE for this model is given by