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Lecture Note 09 - Interest Rate Models
Lecture Note 09 - Interest Rate Models
9-3
Introduction (cont’d)
An interest rate model is a probabilistic description of
how interest rates can change over time. We focus on
one-factor model.
Our approach:
1) To examine how the entire term structure can be
determined based on (1) the initial spot rates (the current
term structure) and (2) the evolution of short-term rate.
• The pricing using the binomial interest rate tree.
2) To study the interest rate models used to build the short-
term rate process.
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Current Term Structure of Spot Rate
Consider six months as one period. Assume that the six-
month and one-year spot rates are 5% and 5.15%,
respectively.
• The price of six-month zero coupon bond is
9-5
One Period Later…
What would the price of the one-year zero coupon
bond be one period (six months) later?
• At that time, the bond becomes a six-month zero coupon
bond.
• The price of the six-month zero coupon bond depends on
the six-month spot rate then.
Assume that six months from now the six-month spot
rate will be either 4.5% or 5.5% with equal real
probability.
9-6
Short-Term Rate Tree
Date 0 Date 1
1/2 5.5%
5%
1/2 4.5%
The binomial tree shows the two states of the world. The
5.5% state will be called the up state and the 4.5% state
will be called the down state.
9-7
Bond Price Tree
Given the current term structure of spot rate, tree for the
price of six-month zero coupon bond is
1/2 1,000
975.61
1/2 1,000
Note:
9-8
Bond Price Tree (cont’d)
The price tree for the one-year zero coupon bond is
1,000
1/2 973.24
1,000
950.42
1/2 978.00
Note:
1,000
,,
9-9
Bond Price vs. Expected Discounted Value
9-11
No-Arbitrage Pricing: Example
Example: what is the time-0 price of a call option,
maturing in six months, to purchase $1,000 face value of
a then six-month zero at $975?
• Note: this is similar to the floorlet – paying interest
payment difference if the six-month rate turns out to be
below the strike rate of 5.13%.
9-12
No-Arbitrage Pricing: Example
If on date 1 the six-month rate is 5.5% -- the up state , a
six-month zero coupon bond will sell for $973.23. The
right to buy that zero at $975 is worthless.
9-13
No-Arbitrage Pricing: Example
Therefore the price tree of the call option is
1/2 0
???
1/2 3
To price the option by no-arbitrage argument, construct a
portfolio on date 0 of six-month and one-year zero
coupon bonds, that will be worth $0 in the up state and
$3 in the down state on date 1.
9-14
No-Arbitrage Pricing: Example
To solve this problem, let F0.5 and F1 be the face value of
six-month and one-year zeros in the replicating
portfolio, respectively. Then, these values must satisfy
the following two equations:
9-16
No-Arbitrage Pricing
In summary, to price a fixed income security with payoff
Vu in the up state and Vd in the down state, solve and in
the following two equations
9-17
Risk-Neutral Probability
A remarkable feature of no-arbitrage pricing (portfolio
replication) is that the probabilities of up and down
moves never enter into the calculation of the no-
arbitrage price.
Risk-neutral probability: the probability that cause the
expected discounted value to equal to the market price.
Let the risk-neutral probabilities in the up and down
states be p and (1 – p), respectively, then
9-18
Risk-Neutral Pricing
The solution is p = 0.8024. In words, under the risk-
neutral probabilities of 0.8024 and 0.1976 the expected
discounted value equals the market price. This should
also apply to other securities.
The market price of the option equals the expected
discounted value. That is,
1/2 1 1/2 0
Pu(0,1) Pd(0,1)
1/2 0 1/2 1
9-21
Pricing Approaches: Summary
We learned three methods to price fixed income security
with one-step binomial tree.
1. Form replicating portfolio directly
2. Compute risk-neutral probability and price random cash
flows with risk-neutral expectation
3. Compute discount factors over states and use them to
price random cash flows
All methods are based on the no-arbitrage assumption
and replicating portfolio.
• We mainly use the risk-neural pricing approach.
9-22
Pros and Cons of One-Step Tree
Pros:
• Easy to compute and easy to understand the basic ideas
Cons:
• Real world doesn’t only have two states
• Many securities have multiple periods rather than one.
Therefore, we need multistep trees.
• Nothing more than a sequence of one-step tree
• Same ideas (no arbitrage on the tree)
9-23
Multi-Period Setting
Assume the three-date (period) tree of six-month rate
(short-term rate) as follows
6%
5.5%
5.00% 5%
4.5%
4%
The tree is called recombining tree. Recombining tress
are much more manageable than non-recombining trees
from a computational viewpoint.
9-24
Prices of 1.5-Year Zero
Assuming that the 1.5-year spot rate is 5.25%. The date-
0 price of the 1.5-year zero coupon bond is then .
On date 3, the zero with an original term of 1.5 years
matures and is worth its face value.
On date 2, the value of the then six-month zero equals its
face value discounted for six months at the then-
prevailing spot rate.
,,
9-25
Price Tree of 1.5-Year Zero
1,000
q 970.87
1,000
0.8024 P1,1
1-q
975.61
925.21 q
1,000
0.1976
P1,0
1-q 980.39
1,000
9-27
Risk-Neutral Interest Rate Process
Solving the three equations to get q = 0.6489, P1,1 =
$946.51 and P1,0 = $955.78.
The risk-neutral interest rate process is
.6489 6%
5.5%
.8024
.3511
5.00% 5%
.6489
.1976 4.5%
.3511
4%
9-28
Risk-Neutral Pricing
The derived risk-neutral interest rate process can be used
to price any fixed income securities with no more than
three periods and with cash flows fixed or contingent on
interest rate.
Price a CMT swap. (In-class exercise.)
It is clear now how the tree can be extended to any
number of dates, given the future possible values of the
short-term rate and a set of bond prices.
Extremely useful in pricing fixed income securities.
9-29
Tree of One-Year Spot Rate
The date-0 one-year spot rate is 5.15% as given. The
date-1 one-year spot rate can be derived from the then-
prevailing price of one-year bond.
• Up state: the price of one-year zero is $946.51 the
one-year spot rate is 5.5736%.
• Down state: the price of one-year zero is $955.48 the
one-year spot rate is 4.5743%.
One-year spot rate tree 5.5736%
5.15%
4.5743%
9-30
Date-1 One-Year Spot Rate
From the price tree of 1.5-year zero:
or .
9-31
Science of Term Structure
Therefore, having specified initial spot rates and the
evolution of the six-month rate, the evolution of long-
term rate can be determined.
• The evolution of yield curve is determined as well.
• Implicit assumption: prices of all fixed income securities
can be determined by the evolution of short-term rate.
• We are using one-factor interest rate model.
• We can also extract implied forward rates and see how
they evolve over time. (In-class exercise.)
9-32
Short-Term Rate Models
To use a multi-step tree to price a security, we need
• Short-term rates on each node of the tree (interest rate
binomial tree)
• All the risk-neutral probability along the tree.
We now deal with the question of how we develop the
interest rate binomial tree.
• Model I: Building a binomial tree from historical
estimates of interest rate volatility and expected future
interest rates (in real probabilities).
9-33
Model I: Using Expected Future Rates
Given expected future rates () and interest rate volatility
(). Assume the length of one period is Δ. Rates are
continuously compounding.
Define the expected change in interest rate in the future
as mi = E[ri+1 – ri]/Δ
We then introduce errors in our predictions:
r1,u = r0 + m0 × Δ + σ (Δ)½
r1,d = r0 + m0 × Δ – σ (Δ)½
for the first period, where up and down movement occur
with probability ½.
9-34
Model I: Using Expected Future Rates
For the second period:
r2,uu = r1,u + m1 × Δ + σ (Δ)½
r2,ud = r1,u + m1 × Δ – σ (Δ)½
r2,du = r1,d + m1 × Δ + σ (Δ)½
r2,dd = r1,d + m1 × Δ – σ (Δ)½
and so on…
This model naturally generates a recombining tree
r2,ud = r0 + (m0 + m1) × Δ = r2,du
9-35
Model I: Using Expected Future Rates
The notation we are using now is not well suited for
longer trees, we pass to the following notation:
9-36
Model I: Using Expected Future Rates
Suppose it is Jan-14 and toady’s 6-month rate: . Given
expected future interest rates
9-37
Model I: Using Expected Future Rates
Given the interest rate volatility:
The 6-month rates on next up and down nodes are
r1,u = r0 + m0 × Δ + σ (Δ)½ = 3.39%
r1,d = r0 + m0 × Δ – σ (Δ)½ = 0.95%
9-38
Model I: Using Expected Future Rates
9-39
Model I: Using Expected Future Rates
We assume that the real probabilities of moving up or
down on each node are half and half (𝑝 = 0.5)
However, as we discussed before, this doesn’t mean that
the risk-neutral probabilities are the same.
9-40
Model I: Using Expected Future Rates
Suppose in Jan-14, the prices of zeros are
9-42
Model I: Using Expected Future Rates
Suppose we already find and , now looking for . The
following tree shows that using the p = ½ cannot match
the price.
9-43
Model I: Using Expected Future Rates
Using excel, we can easily find the so that the
calculated price is equal to the observed price (as shown
below).
9-44
Model I: Using Expected Future Rates
We used the given expected future rates, interest rate
volatility, and the yield curve to construct a multi-step
tree (with the short-term rate on each node as well as the
risk-neutral probability to reach each node.)
We can use this tree to price other securities by
computing risk-neutral expectations.
• The underlying mechanism is dynamic replicating
portfolio and no-arbitrage condition
9-45
Model II: KWF Model
In a 1993 FAJ paper, Kalotay, Williams, and Fabozzi first
introduced the following interest rate model:
• Given benchmark interest rates and an assumed interest
rate volatility.
• Assume the risk-neutral probability of up move and down
move the same (1/2).
• The short-term rates at the up and down node are related
so to match the given interest rate volatility .
• The short-term rate at the down node is chosen so to
match the given yield curve (spot rates).
9-46
KWF Model: Example
Assume you have the following observed yield curve
and assume annual coupon payment
Y i e ld t o
Maturity Market
M a t u r i t y (%)
Years Value
1 100
3.50
2 100
4.00
3 100
4.50
The spot rates can then be determined by
9-47
KWF Model: Example
The forward rates can be calculated as follow:
9-49
Model II: KWF Model
spot
9-50
KWF Model: Example (cont’d)
Assume the volatility is 10%. Based on the given
benchmark interest rate, . has to be the value so that the
2-year 4% par bond is priced at par:
9-51
KWF Model: Example (cont’d)
9-52
Model II: KWF Model
Use the derived risk-neutral binomial tree, we can value
any fixed income securities with no more than three
periods and with cash flows fixed or contingent on
interest rate.
• The tree has been used in previous lectures. (Refer to
lecture note 05 and lecture note 07.)
• For valuation of securities with future cash flows fixed,
using the tree or using the spot rates information produce
the same answer. For example, valuation of the standard
5.25% 3-year coupon bond.
9-53
More Discrete-Time Models
The problems with model I:
• There is no guarantee that the calibrated risk-neutral
probability
9-55
Model III: The Ho-Lee Model
An example:
• Consider the following term structure of interest rates: the
zero coupon bond expiring on date k = 1 is P0(1) =
99.1338, implying r0 = 1.74% (the root of the tree)
• In the data, the zero coupon bond expiring on date k = 2 is
P0(2) = 97.8925
• We now choose θ0 so that the binomial tree exactly gives
P0(2) as price.
• At the time the data gave σ = 0.0173.
9-56
Model III: The Ho-Lee Model
We choose θ0 so that the following equation is satisfied
9-60
Model IV: The BDT Model
The main drawback of the Ho-Lee model is that it
allows negative interest rates.
The BDT solves this by defining:
zi,j = ln(ri,j)
Then for zi,j we have the process:
9-62
Model III and Model IV: Comparison
The following figure shows the risk neutral distribution of
interest rates at T = 5 using 500 steps.
9-63
Model III and Model IV: Comparison
These differences are not important for bond prices, as
both models exactly match the term structure of interest
rates
9-64
Interest Rate Models in Continuous Time
9-65
Interest Rate Models in Continuous Time
with p* = 0.5
9-66
Three simulated interest rate paths from the Ho-Lee model. As n
increases and Δ gets smaller, the interest rate process becomes more
‘jagged’ and the number of possible outcomes at T = 1 increases
9-67
The statistical distribution of Ho-Lee interest rates at T = 1 as n increases.
(1000 paths simulated.) As n increases (Δ decreases) the distribution of
interest rates at time T = 1 converges into a normal distribution.
9-68
This is true even if we fix T to any other number, even a very small one:
as Δ → 0, then the distribution of rates at T will be Normal. (The standard
deviation increases in .)
9-69
Interest Rate Models in Continuous Time
9-71
Drift and Risk Premium Model
Example: suppose the current value of the short-term
rate is 5.138%, the volatility equals 110 basis points per
year, the drift of the rate per year is 22.9 basis points.
That is,
,,
If the realization of the random variable is 0.15 over a
month, then the change in rate is
9-72
Drift and Risk Premium Model
The drift of the rate in the example is or 1.9 basis
points per month.
The drift in the process is a combination of the true
expected change in the interest rate and of a risk
premium.
• A drift of 1.9 basis points per month may arise because
the market expects the short-term rate to increase by 1.9
basis points a month, because the short-term rate is
expected to increase by one basis point with a risk
premium of .9 basis points, or because …
9-73
Drift and Risk Premium Model
The tree approximation of this model is:
𝑟 0 +2 𝜆 𝑑𝑡+2𝜎 √ 𝑑𝑡
1/2
𝑟 0 +𝜆 𝑑𝑡+𝜎 √ 𝑑𝑡
1/2
1/2
𝑟0 𝑟 0 +2 𝜆 𝑑𝑡
1/2
1/2
𝑟 0 +𝜆 𝑑𝑡 − 𝜎 √ 𝑑𝑡
1/2
𝑟 0 +2 𝜆 𝑑𝑡 −2 𝜎 √ 𝑑𝑡
9-74
Time-Dependent Drift Model
The dynamics of the risk-neutral process in the Ho-Lee
model are written as
9-75
Time-Dependent Drift Model
The corresponding tree of Ho-Lee model is
𝑟 0 +𝜆 1 𝑑𝑡+𝜎 √ 𝑑𝑡
1/2
1/2
𝑟0 𝑟 0 +(𝜆1 + 𝜆2 )𝑑𝑡
1/2
1/2
𝑟 0 +𝜆 1 𝑑𝑡 − 𝜎 √ 𝑑𝑡
1/2
𝑟 0 + ( 𝜆1+ 𝜆2 ) 𝑑𝑡 − 2 𝜎 √ 𝑑𝑡
9-76
Mean Reversion Model
The risk-neutral dynamics of the Vasicek model are
written as
9-78
Mean Reversion Model
Example of tree representation
9-79
Mean Reversion Model
Based on the specification, the expectation of the rate in
the Vasicek model after T years is
9-80
Other One-Factor Models
Time-dependent volatility model:
Lognormal model
9-81
Multi-Factor Term Structure Models
Previous models are single-factor term structure models
The entire term structure of interest rates can be
explained by changes in a single interest rate
The models differ in how that single rate impacts the
term structure, whether through a parallel shift or a
short-lived shock
All rates in the model are perfectly correlated
9-82
Multi-Factor Term Structure Models
Knowing the change in one rate may not be sufficient
enough to predict perfectly how other rates change
A multi-factor term structure model is more adequate for
professionals who want to manage risk of the entire term
structure
9-83
Two-Factor Mean Reversion Model
A two-factor Vasicek model can be written as
9-84
Two-Factor Mean Reversion Model
For the two-factor model to provide better explanatory
power than a one factor Vasicek model, the two factors
have to be materially different from one another.
Typically, the first factor is a long-lived factor with
relatively low mean reversion speed and the second
factor is a short-lived factor with relatively high mean
reversion speed
9-85
Summary
Models need enough flexibility so that they can be
calibrated to capture the essence of market behavior.
Models need enough structure to be useful for valuation
and hedging
• A simple one-factor model imposes parallel shifts and
concludes that any security can be perfectly hedged with
one other security
• A model with many factors can fit all observed rates and
volatilities but will not be able to identify any overvalued
or undervalued securities
9-86
End of the Notes!
9-87