Module 5: Interest Rate Models

Forward Bond prices and interest rates Binomial Interest Rate Trees
Here, Interest Rates are no longer constant over time, They show the interest rate evolution under the risk
but they change randomly neutral world.
A binomial tree for interest rates looks quite similar to
Let P (t, T ) be the time-t value of a zero-coupon bond a binomial tree for stocks prices, but they are funda-
(ZCB) that pays 1 at time T mentally very different:
The interes rates are the rates applicable during
Let r(t, T ) denote its associated yield to maturity.
some time intervals.

For continuous compounding we have: The rates are given or implied by some indirect
methods; so, we don’t need to compute u, dp2
To price bonds and interest rate options, it’s bet-
P (t, T ) = exp{−r(t, T )(T − t)}
ter to write down all possible paths
The risk-neutral probability weights the zcb pri-
ces and never the rates unless they are the payoof
For non-continuous compounding we have: we need to discount.
Black-Derman-Toy Model
P (t, T ) = (1 + r(t, T ))−(T −t)
It is an equal-probability tree (p∗ = 1/2) and a re-
combining binomial tree that models the evolution of
effective anual yields. The structure of the tree with
The function t −→ r(0, t) is called the zero-coupon the time-step h is
yield curve

The time-t forward price of the time-T delivery of a

s-year ZCB is

P (t, T + s)
Ft,T [P (T, T + s)] :=
P (t, T )

A forward rate is the rate implied by the forward bond

price. such that √
ru (ih,(i+1)h)
Notice that rd (ih,(i+1)h) = e2σi h

Ft,T [P (T, T + s)] = exp{−rt (T, T + s)(s)} The BDT tree is completely specified by the rate level
and volatility parameters Rih ’s and σi ’s
Yield Volatility
In general, this is not the σ but the annualized stan-
dard deviation of the log of the yield for that bond 1
period hence.
e.g. the period-2 (period (h, 2h)) yield volatility is
1 y
√ ln u = σ
2 h rd
the period-3 (period (h, 3h)) yield volatility is
1 y
√ ln u = σ : yu = [Pru (h, 3h)](−1/2h) − 1
2 h rd

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 Module 5: Interest Rate Models

The Black Model The Black Formula for Interest Rate Caplets

An interest rate caplet pays [r(T, T + s) − K]+ at

Put-Call Parity for Options on ZCB time T + s (Not T !). By discounting the payoff at time
T , we have
Call(K, T ) − P ut(K, T ) = P (0, T + s) − KP (0, T ) P (T, T + s)[r(T, T + s) − K]+
 
1 + r(T, T + s)
for a T-year K-strike call and put options on a s-year = P (T, T + s)(1 + K) −1
zero-coupon bond maturing at T+s, whose payoffs 1+K +
 
[P (T, T + s) − K]+ and [K − P (T, T + s)]+ are paid at 1
= (1 + K) − P (T, T + s)
time-T 1+K +

Thus, the caplet is equivalent to (1+K) units of T -year

The Black Model for Bond Options put on P (T, T + s) with strike 1/(1 + K).

Suppose we are standing at time 0, the Black Mo- Notice that r(T, T +s) is not continuously compounded
del assumes that the forward price process and non-annualized.

P (t, T + s)
Ft,T [P (T, T + s)] = , 0≤t≤T
P (t, T )

follows a GBM. Here the GBM starts at the time-0

forward price F0,T [P (T, T + s)] = PP(0,T +s)
(0,T ) , and ends
al time-T value of FT,T [P (T, T + s)] = PP(T,T +s)
(T,T ) =
P (T, T + s). Thus, the Black Model implies that
P (T, T + s) is lognormally distributed.

The Black Formula for Bond Options

For a T-year K-strike options on a s-year ZCB we have

V (K, T ) = P (0, T )[φF N (φd1 ) − φKN (φd2 )]

where

F = F0,T [P (T, T + s)]

   
1 F 1
d1 = √ ln + σ2 T
σ T K 2
√
d2 = d1 − σ T

Here, σ is the s-year forward bond price volatility;

for 0 < t ≤ T

1
σ2 = V ar [ln Ft,T (T, T + s)]
t  
1 P (t, T + s)
= V ar ln
t P (t, T )

1
If t = T, σ2 = V ar [ln P (T, T + s)]
T

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 Module 5: Interest Rate Models

An Equilibrium Equation for In- Volatility of an IRD

terest Rate Derivatives
σ(rt )Vrt (rt , t, T )
One Factor Interest Rate Models q(rt , t, T ) = −
V (rt , t, T )
Let rt be the instantaneous risk-free interest rate at
time t. Here, rt is random and its dynamics is governed Risk Neutral Valuation
by the next SDE
The risk neutral world Q is defined by
drt = a(rt )dt + σ(rt )dZt
Z t
The SharpeRatio of an InterestRateDerivative Z̃t = Zt − φ(rs , s)ds (dZ̃t = dZt − φ(rt , t)dt)
0

Let V (rt , t, T ) be the time-t price of the interest rate

The risk-neutral dynamics of short rate is given by:
derivative maturing at time-T , if
dV (rt , t, T ) drt = [a(rt ) + σ(rt )φ(rt , t)]dt + σ(rt )dZ̃t
= α(rt , t, T )dt − q(rt , t, T )dZt
V (rt , t, T )
Every interest rate derivative earns a risk-free rate un-
then the Sharpe Ratio is der the Q measure, and hence we can price it by dis-
counting at the risk-free rate:
α(rt , t, T ) − rt
φ(rt , t) =
q(rt , t, T ) ( Z
T
) !
V (rt , t, T ) = E∗ exp − rs ds V (rT , T, T ) | rt
Again, the Sharpe Ratio of any Interest Rate Derivati- t
ve is the same (it implies that it only depends on t and
rt , but not the maturity of the payoff of the derivative). ( Z ) !
T
Moreover, if you own an interest rate derivative V1 , ∗
⇒ P (rt , t, T ) = E exp − rs ds | rt
whose dynamics is t

dV1 (rt , t, T1 )
= α1 (rt , t, T1 )dt − q1 (rt , t, T1 )dZt , Greek Letters for Interest Rate Derivatives
V1 (rt , t, T1 )
and if there is another interest rate derivative V2 so ∂V (rt , t) ∂ 2 V (rt , t)
that ∆= ; Γ=
∂rt ∂ 2 rt
dV2 (rt , t, T2 )
Suppose that V (rt , t, T ) = P (rt , t, T ) is the time-t pri-
= α2 (rt , t, T2 )dt − q2 (rt , t, T2 )dZt ,
V2 (rt , t, T2 ) ce of a zero-coupon bond that matures at time T . We
then you can hedge interest rate risk by trading N units say that P has a affine structure if
of V2 , where
P (rt , t, T ) = A(t, T )exp{−rt B(t, T )}
q1 (rt , t, T1 )V1 (rt , t, T1 )
N =−
q2 (rt , t, T2 )V2 (rt , t, T2 ) for some functions A(t, T ) and B(t, T ) that do not de-
pend on rt , then
The Term Structure Equation
∂P (rt , t, T )
∆= = −B(t, T )P (rt , t, T )
For any derivative price V = V (rt , t, T ) we have the ∂rt
term structure equation:

∂2V ∂ 2 P (rt , t, T )
∂V
+ [a(rt ) + σ(rt )φ(rt , t)]
∂V 1
+ [σ(rt )]2 2 = V rt Γ= = B 2 (t, T )P (rt , t, T )
∂t ∂rt 2 ∂ rt ∂ 2 rt

The pricing formula for any derivative must satisfy Moreover, the volatility of the bond is
the term structure equation above. It is parallel to the
Black-Scholes equation. σ(rt )Prt (rt , t, T )
q(rt , t, T ) = − = σ(rt )B(t, T )
P (rt , t, T )

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 Module 5: Interest Rate Models

Rendleman-Barter, Vasicek and Cox-Ingersoll-Ross Model

Under this model, rt follows the next SDE
Cox-Ingersoll-Ross Models
√
drt = a(b − rt )dt + σ rt dZt
Rendleman-Barter Model √
rt
where a ≥ 0, b > 0, φ(rt , t) = φ̄
Under this model, rt follows a GBM σ
rt exhibits mean reversion and is always non-negative.
drt = art dt + σrt dZt
The process of rt in the Q measure has the same form
as that in the P measure
where a ∈ R, σ > 0, φ(r, t) = φ is a constant.
Bond price under the CIR Model:
The bond price has an affine structure,
Vasicek Model
P (rt , t, T ) = A(T − t)exp{−rt B(T − t)};
Under this model, rt follows a OU-process
 1
 2ab
2
σ
2γe 2 (a−φ̄+γ)(T −t)
drt = a(b − rt )dt + σdZt A(T − t) = (a−φ̄+γ)(eγ(T −t) −1)+2γ

γ(T −t)
2(e −1)
where a ≥ 0, b > 0, φ(r, t) = φ is a constant. B(T − t) = (a−φ̄+γ)(e γ(T −t) −1)+2γ

q
t
¯ 2 + 2σ 2
Z
⇒ rt = b + (r0 − b)e −at
+σ e−a(t−s) dZs γ = (a − φ)
0
√
rt is mean-reverting: a controls the speed of ⇒ q(rt , t, T ) = σ rt B(T − t)
mean-reversion, b is the level to which rt reverts. 2ab
lı́m y(rt , t, T ) =
T →∞ a − φ̄ + γ
rt can be negative

In Q measure, rt still follows an OU-process

drt = [a(b − rt ) + σφ]dt + σdZ̃t

σφ
= a(b0 − rt )dt + σdZ̃t ; b0 = b +
a

Bond price under Vasicek Model:

The bond price has an affine structure,

P (rt , t, T ) = A(T − t)exp{−rt B(T − t)};

 
B 2 (T −t)σ 2
A(T −t) = exp r̄(B(T − t) + t − T ) − 4a

1−e−a(T −t)
B(T − t) = a

σφ σ2
r̄ = b + a − 2a2

1 − e−a(T −t)
⇒ q(rt , t, T ) = σB(T − t) = σ
a
Consider that for the continuously compounded yield
to maturity y such that P (rt , t, T ) = e−y(rt ,t,T )(T −t)

lı́m y(rt , t, T ) = r̄;

T →∞