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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
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
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
●
●
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
Reversion
Level
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
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
●
This model cleverly estimates the unobservable (latent) variance.
●
The model is not efficient when “q” is large
●
Generalized ARCH model
●
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
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