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One Factor and Two Factor

Interest Rate modeling

Presented By :-
Pravesh Surana
Ravi Somani
Raounak J
Interest rate model or process
It is important to recognize that the interest rate model or process that underlies
fixed income securities is quite different from equity or FX process such as lognormal
diffusion

Interest rates display mean reversion and may have volatility dependent on the
interest level

Bill or bond prices that depend on the underlying interest rates also converge to (or
pull to) par at maturity

An Interest Rate Tree or Interest Rate Lattice is a Numerical Representation of the


Interest Rate Model. It facilitates the numerical computations of derivative prices
based on the interest rates. One common representation is the binomial tree.

The lattice is a time-discrete process. It may be a discrete model in its own right, or it
may serve as a discrete approximation to a continuous time model.
Changes in interest rates: Argentina, Brazil, Chile, Mexico and HK
6 2

4
1
2

0 0

-2
-1
-4

-6 -2
2/08/94 1/09/96 12/09/97 2/08/94 1/09/96 12/09/97

A rgenti na/P esos A rgentina/D ollars

60 4

40
2

20
0
0
-2
-20

-4
-40

-60 -6
2/08/94 1/09/96 12/09/97 2/08/94 1/09/96 12/09/97

B raz il C hi l e

10 40

30
5
20

0 10

0
-5
-10

-10 -20
2/08/94 1/09/96 12/09/97 2/08/94 1/09/96 12/09/97
Terminologies

It is a model where the stochastic changes depend on one random factor or
ONE-FACTOR INTEREST noise in the economy. this implies all the interest rates of different maturities
will be perfectly correlated.
RATE MODEL ●
A one-factor model is conveniently represented by a binomial tree.


Examining the drift term, we see that for large r the (risk-neutral) interest
rate will tend to decrease towards the mean, which may be a function of
Mean Reversion ●
time.
When the rate is small it will move up on average.

Spot Rates A spot rate, for maturity T is the rate of interest earned on an

investment that provides a payoff only at time T .


The forward rate is the future spot rate implied by today’s term
Forward Rates structure of interest rates.
Mean Reversion
(Hull: Figure 28.1, page 651)
Interest
rate

HIGH interest rate has negative trend

Reversion
Level

LOW interest rate has positive trend


Models
Vasicek Model

Cox, Ingersoll & Ross Model

Ho & Lee Model

Hull & White Model

ARCH Model

EWMA Model
Vasicek
• The Vasicek model is a particularly simple form:

dit     it  dt  dz

Controls Persistence
Controls Variance
Controls Mean
Using the Vasicek Model
• Choose parameter values
• Choose a starting value
• Generate a set of random numbers with mean 0 and variance 1

dit  .2 6  it  dt  2dz


i0  6%

t=0 t=1 t=2 t=3 t=4


i 6% 6.8% 6.84% 4.202% 5.5616%
.2(6-i) 0 -.16 -.168 .3596
dz .4 .1 -1.1 .5
di .8 .04 -2.368 1.3596 -.9
Vasicek (sigma = 2, kappa = .17)
0.2
0.18
0.16
Path1
0.14
Path2
0.12
Path 3
0.1
Path 4
0.08
Path 5
0.06
Average
0.04
0.02
0
24

40

64

72

80
0
8
16

32

48

56

88

96
Cox, Ingersoll, Ross (CIR) Model

• The CIR framework allows for volatility that depends on the current level
of the interest rate (higher volatilities are associated with higher rates)
• dr = k(μ-r)dt + σ√r dZ
• μ is the long run equilibrium rate of interest towards which the short
rate reverts
• k is a measure of speed at which the gap is reduced
• This formulation is sometimes referred to as a mean reversion model
• σ is a partial measure of interest rate volatility and is assumed to be
constant, the full measure of volatility σ√r will depend on the level of
interest rates
• The model does not allow interest rates to be negative
• Does not allow interest rates to “explode” to levels without bounds
Cox, Ingersoll, Ross (CIR) Model
• This models of the term structure was solved in closed
form by CIR. The price of a zero coupon bond is given by:
• P(r,τ) = A(τ)eB(τ)r
where
• A(τ) = [2γe(k- γ) τ/2/g(τ)]2kμ/σ2
• B(τ) = -2(1-e-γτ)/g(τ)
• g(τ) = 2γ + (k-γ)(1-e-γτ)
• γ = √k2 + 2σ2
• τ = T- t
Alternative Term Structures in CIR
ARCH MODEL
Few measures of volatility:
• Actual: at particular time.
• Historical/realized: for some period in the
past.
• Implied: used in Black-Scholes model for
option pricing
• Forward: for some period in future.
Assumptions Of ARCH Model
In developing an ARCH model, you will have to
provide three distinct assumptions
• one for the conditional mean equation
• one for the conditional variance
• one for the conditional error distribution.
Why ARCH Model is used??
The ARCH-M model is often used in financial
applications where the expected return on an
asset is related to the expected asset risk. The
estimated coefficient on the expected risk is a
measure of the risk-return tradeoff.
ARCH Model

Moving-window volatility; observe the plateauing.



Auto-Regressive Conditional Heteroskedasticity

ARCH Engle (1982)



This model cleverly estimates the unobservable (latent) variance.

The model is not efficient when “q” is large


Generalized ARCH model

GARCH Bollerslev (1986)



Glosten, L.R., R. Jagannathan and D. Runkle (1993), "Relationship between the
Expected Value and the Volatility of the Nominal Excess Return on Stocks,"


Non-linear ARCH model

NARCH

Higgins and Bera (1992) and Hentschel (1995)

These models apply the Box-Cox transformation to the conditional variance.

The variance depends on both the size and the sign of the variance which helps to capture
leverage type (asymmetric) effects.


Threshold ARCH Model
TARCH ●


Rabemananjara, R. and J.M. Zakoian (1993)
Large events to have an effect but no effect from small events


Switching ARCH
Hamilton, J. D. and R. Susmel (1994)
SWARCH


In SWARCH models, the states refer to the states of volatility. For a 2-state
example, we have “high,” or “low” volatility states.
EWMA Model
• In an exponentially weighted moving average
model, the weights assigned to the u2 decline
exponentially as we move back through time,
and the decline rate is 
• This leads to
  
2
n
2
n 1  (1   ) u 2
n 1

18
Attractions of EWMA
• Relatively little data needs to be stored
• We need only remember the current estimate
of the variance rate and the most recent
observation on the market variable
• Tracks volatility changes
• Risk Metrics uses l = 0.94 for daily volatility
forecasting
EWMA Model


σn 2  (1  λ)  λ i 1 R 2 n  i  1
i 1

Exponentially weighted volatility; no plateauing.


Ho and Lee

dr = q(t )dt + sdz


• Many analytic results for bond prices
and option prices
• Interest rates normally distributed
• One volatility parameter, s
• All forward rates have the same
standard deviation
Diagrammatic Representation of
Ho and Lee (Figure 28.3, page 655)

Short r
Rate
Initial Forward
r Curve
r

r
Time
Hull and White Model
dr = [q(t ) – ar ]dt + sdz
• Many analytic results for bond prices and
option prices
• Two volatility parameters, a and s
• Interest rates normally distributed
• Standard deviation of a forward rate is a
declining function of its maturity
Diagrammatic Representation of Hull and
White (Figure 28.4, page 656)
r
Short
Rate
r Forward Rate
Curve
r

r
Time

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