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06/16/2009

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Approximatingpricesofbondswithlog-normal  interestrate   
SankarshanBas
an
AngelosDassios 
Abstrac
Thispapercalculatesboundsforthepricesofbondsforvariousinterestratemodelsresultinginlog-normaldistributionfortheinterestrate,intwodierentways.Intherstmethodweemploy aconditioningfactoraswasdonebyRogersandShi,toapproximatethepricesofAsianoptionsThesecondmethodisviaadirectexpansion.Thelowerboundsobtainedaresoaccuratethatheyareessentiallythetrueprices.Thepaperalsolooksatvaluesofcontingentpaymentsonthe interestrate. 
Keywords
Gaussianprocesses,log-normalinterestrates,Brownianmotion,OrnsteinUhlenbecprocess,bonds,option
AMS1991subjectclassication
90A09,60G1
1Introduction 
Lettheinstantaneousrateofinteres
begivenby 
b
 
wher
isaGaussianprocesswithzeromeanandavariance-covariancCov( 
;
)
 
u
 
isthedriftof 
an
isascalingfactorwhoseimportancewillbecomeapparentinthenext section.Inourexamplesitwillrepresentthevalueof 
atspecictimepoints.Ourmodelcan beputintheframeworkoftheworksetoutbyHeath,JarrowandMorton(1992);seealsoBaxte
DepartmentOfStatisticsTheLondonSchoolofEconomicsandPoliticalScienceHoughtonStreetLondonWC2A2AE, U.K
 
andRennie(1996).ItisanextensionoftheworkbyBlackandKarasinski(1991),aswellasBlack, DermanandToy(1990).Whe
isaBrownianmotion,themodelisknownastheBlack-Derman- Toymodel.Inthelasttwoworks,abinomialtreeapproachhasbeenusedtocalculatethepricesAsimilarapproachisusedbyHullandWhite(1993)whoessentiallyuseatrinomialtree.TheHulandWhitemodelisquitesimilartotheVasicek(1977)model.IntheHullandWhitemodelasiourcase,theinterestratecannotbecomenegative;thiswouldhavehadundesiredconsequencesas hasbeenshownbyRogers(1995)Inthecourseofthiswork,welookintotheproblemsofcalculatingboundsforthepriceofthe bond,intwoways-rstbytheuseofasuitableconditioningfactorasinRogersandShi(1995andalsoalternativelybydirectexpansion.Wealsolookatthevaluingcontingentpaymentsonthe interestrate.Amoregeneralproblemisthecalculationof 
 
Z  
 
d
)
wher
isaconvexfunction.Thus,inparticularthepriceofthebond(f(x)
 
b
)isgivenby 
 
 
d
)(1andthevalueofthecontingentpayment(f(x)= 
 
b
  
)isgivenby 
 
 
d
  
(2RogersandShilookatf(x)
=max
x
0).Theyalsoassumetha
isaBrownianmotion. Tocalculatethepriceofthebondandcalloption,wemakeuseofaconditioningfactorZ.Aloweboundcanbeobtainedusingthefactthat 
))
)
  
))
SeveralchoicesofZasaconditioningfactorhavebeentriedbyRogersandShi,aswellasus.Ifact,wehavefound,empirically,thatthebestchoiceofZ,inallcasesi
d
q  
Va
d
.Zithiscasefollowsastandardnormaldistribution. Thedirectexpansionmethodusedinhereisonlyconcernedwiththecalculationofthepricesforthe bond.TheprimaryreasonforusingthetwomethodsisthatitprovidesameasureofcomparabilityInthevaluationofcontingentpaymentsontheinterestrate,thedirectmethodcannotbeusedand henceweresorttotheuseofsimulatedvaluestochecktheaccuracyoftheconditioning. 
2Calculationsusingconditioning 
Asmentionedabove,weconditiononZ.ConditionallyonZ
isaGaussianprocesswit
)
Z
(3
 
wher
=Cov
;
)
Cov( 
;
d
q  
Var
d
(4andCov
;
)
 
u
  
u
sa
(5Weareinterestedincalculatingalowerbound(L
intables1,2and3)andthecorresponding upperbound(U
intables1,2and3).Wedothatbyconsideringthefollowingargument.Therexistssomevariabl
 
suchthat 
))
 
))]
  
)
))]
  
)
0
 
)
so
))
))
  
)
0
 
)
)   
 
))
  
)
  
 
))]
  
)
su
 
0
Thus,inthecasewheref(x)
 
b
,thelowerboundisgivenby L
 
))](6andthecorrespondingupperboundisgivenby U
=L
E(Var
)
(7sincesu
 
0
)
.Her
 
d
.Thus
Var( 
Z  
 
d
)]
 
Z  
Z  
dudv 
  
Z  
d
)
Z  
Z  
u
  
1
dudv: 
(8Letusdene 
)
Z  
 
d
)
Z  
u
du
(9Inthecaseofcalculatingthepriceofthebond
 
 
 
d
thelowerboundisgivenbyL
Z  
 
b
p   
 
 
d
(10andthecorrespondingupperboundisgivenby U
Z  
 
b
p   
 
 
d
Z  
Z  
u
  
1
dvdu: 
(11

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