Slide Analisa Pasar Modal 210910

An Introduction to Capital Markets
and Investment∗
Dr. Ir. Budhi Arta Surya
September 21, 2010
∗ The materials of this course are based on the references listed at the end of this slide.
An Introduction to Capital Markets and Investment
Preliminary
An Introduction to Capital Markets and Investment, SBM-ITB, August 2010 1

Definitions and Conventions
Before we proceed with the content materials of this course, let us first make some
definitions and conventions that will be used throughout this course.
Denote by Pt the price of an asset at date t. Assume that this asset pays no dividends.
The simple net return, Rt, on the asset between dates t − 1 and t is defined as
Pt
Rt = − 1.
Pt−1
The simple gross return on the asset is 1 + Rt.
The asset’s multiyear gross return 1 + Rt (n) over recent n periods is defined by
Pt Pt Pt−1 Pt−2 Pt−n+1
1 + Rt(n) := = × × × ··· ×
Pt−n Pt−1 Pt−2 Pt−3 Pt−n
= (1 + Rt ) × (1 + Rt−1) × · · · × (1 + Rt−n+1)
n−1
Y
= (1 + Rt−j ).
j=0

Definitions and Conventions: Continued
Multiyear returns are normally annualized to make investments with different horizons
comparable. The annualized multiyear return is defined by
h n−1
Y i 1/n
a
Rt (n) = (1 + Rt−j ) − 1.
j=0
If single-period returns Rt’s are relatively small in magnitude, first-order Taylor

approximation simplifies the annualized multiyear return as
n−1
1X
Rta (n) ≈ Rt−j .
n j=0
Continuous Compounding The continuously compounded return or log return rt of

an asset is defined to be the natural algorithm of its gross return (1 + Rt ):
Pt
rt := log(1 + Rt ) = log = pt − pt−1, where pt := log Pt .
Pt−1
To distinguish Rt from rt , we shall refer to Rt as a simple return.

Continuous Compounding: Continued
The continuously compounded returns become advantageous when considering

multiperiod returns, since
n−1
Y n−1
X n−1
X
rt(n) = log(1 + Rt (n)) = log (1 + Rt−j ) = log(1 + Rt−j ) = rt−j .
j=0 j=0 j=0
Drawbacks of Continuously Compounded Returns
Consider a portfolio of N assets whose value is given by

N
X N
X
Vt = #j (t)Ptj −→ Rtp = θj (t)Rtj ,
j=1 j=1
j
#j (t)Pt
where #j (t) is the number of assets j held at time t and θj (t) = Hence, Vt .
the simple return Rtp of the portfolio is a weighted average of the returns of individual
assets. However, continuously compounded returns do not have this property, i.e.,
N
X
rtp 6= θj (t)rtj .
j=1

Distributional Properties of Asset Returns
• Normal Distributional Properties
One of the most common models for asset returns is the independent and identically
distributed (IID) normal model, in which returns are assumed to be independent over
time, identically distributed over time, and normally distributed. The original
formulation of the CAPM employed this assumption of normality.
Remarks The normality assumption suffers from at least two important drawbacks:
• The smallest net return achievable is −1 whereas the normal distribution’s support
is the entire real line. Hence, the lower bound of −1 is clearly violated.
• If single-period returns are assumed to be normal, then multiperiod returns cannot
also be normal since they are the products of the single-period returns.
• Log-Normal Distributional Properties

As alternative, log-returns rit = log 1 + Rit are assumed to be normal, i.e.,
2
rit ∼ N (µi , σi ).

• Log-Normal Distributional Properties: Continued
Under the lognormal assumption, if the mean and variance of rit are µi and σi2,
respectively, then the mean and variance of simple returns are given by
µi +σi2/2
E Rit = e −1
(1)
2µi +σi2 σi2
Var Rit = e e −1 .
The lognormal model has a long history dating back to the dissertation of Bachelier
(1900) and the work of Einstein (1905), containing the math of Brownian motion and
heat conduction. The model has underpinned the financial asset pricing theory.
• Non-Normal Distributional Properties of Log-Returns
The stylized fact of log-returns exhibit a deviation from the normality assumption. At
short horizons, historical returns show weak evidence of skewness and strong evidence
of excess kurtosis. The normal distribution has skewness 1 equal to zero, as do all
other symmetric distributions, and kurtosisequal to 3, but fat-tailed distributions with
extra probability mass in the tail areas have higher or even ∞ kurtosis.
h 3i h i
1 Normalized third and fourth moment of a r.v. X is defined by E (X−µ) (X−µ)4
and E , respectively.
σ3 σ4

Distributional Properties of Asset Returns: Continued

Histogram of data Generalized Hyperbolic Q−Q Plot
30
Asymm NIG Asymm NIG
Gaussian Gaussian
0.10
25
0.05
20
Sample Quantiles
log(Density)
0.00
Density
15
−0.05
10
−1
−0.10
5
−2
−0.15
0
−3
−0.15 −0.05 0.05 −0.15 −0.05 0.05 −0.15 −0.05 0.05 0.15
data ghyp.data Theoretical Quantiles
Figure 1: Histogram and density fits of Normal and NIG distributions to log-return of
CS data. Observe that the assumption on normality of the log-return is violated.

Efficient Capital Markets

Efficient Market Hypothesis
The origins of the Efficient Market Hypothesis2 can be traced back to
• the pioneering theoretical contribution of Bachelier (1900) and the empirical

research of Cowles (1933).
• In modern theory of economics, the work of Samuelson (1965) whose contribution
can be neatly summarized by the title of his article:
”Proof that Properly Anticipated Prices Fluctuate Randomly”.
Referring to Samuelson, in an informationally efficient market price changes must
be unforecastable if they are properly anticipated, i.e., if they fully incorporate the
expectations and information of all market participants.
• Fama (1970) who summarizes this idea in his survey:
”A market in which prices always ’fully reflect’ available information is called
’efficient’ ”.
2 We refer to Bernstein (1992) and Lo (1996) for further literature study on the contributions of Bachelier, Cowles,
Samuelson, and many other early authors.

Efficient Market Hypothesis: Continued
More recently, Malkiel (1992) has offered the following more explicit definition:
Definition 1. A capital market is said to be efficient if it fully and correctly reflects

all relevant information in determining security prices. Formally, the market is said to
be efficient with respect to some information set...if security prices would be
unaffected by revealing that information to all market participants. Moreover,
efficiency with respect to an information set...implies that it is impossible to make
economic profits by trading on the basis of that information set.
Remarks on Malkiel definition of EMH
• The first sentence of Malkiel definition repeats Fama’s definition.

• The second sentence suggests that market efficiency can be tested by revealing
information to market participants and measuring the reaction of security prices.
If prices do not move when information is revealed, then the market is efficient
with respect to that information.
• Malkiel’s third sentence suggests an alternative way to judge the efficiency of a
market, by measuring the profits that can be made by trading on information.

Malkiel’s idea on measuring the market efficiency by measuring the profits that can be
made by trading on information lays the foundation of almost all the empirical work on
market efficiency. It has been used in two main ways.
• First, many researchers have tried to measure the profits earned by market
professionals such as mutual fund managers. If these managers achieve superior
returns (after adjustment for risk) then the market is not efficient with respect to
the information possessed by the fund managers.
• This approach has the advantage that it concentrates on real trading by real
market participants.
• But is has the disadvantage that one cannot directly observe the information
used by the managers in their trading strategies3.
• Alternatively, one can ask whether hypothetical trading based on an explicitly

specified information set would earn superior returns. To implement this approach,
one must first choose an information set.
3 see Fama (1970,1991) for a thorough review of this literature.

According to Roberts (1967), the classic taxonomy of information sets can be divided
into three forms:
• Weak-form Efficiency The information set includes only the history of prices or
returns themselves.
• Semistrong-form Efficiency The information set includes all information known
to all market participants (publicly available information).
• Strong-form Efficiency The information set includes all information known to any
market participant.

The Law of Iterated Expectations
As discounted present-value model of security prices is found to be entirely consistent

with randomness4 in the security returns, the key to understanding the randomness
feature/behavior of security returns is the so-called Law of Iterated Expectations.
Samuelson (1965) was the first to show the relevance of the Law of Iterated
Expectations for security market analysis5 .
To state the law, let us define two information sets (sometime known as filtrations)
Ft and Gt that are available to market participants at time t, where Ft ⊂ Gt so that
all the information contained in Ft is also contained in Gt , i.e., Gt contains extra
information compared to Ft . (In this case Gt is also known as enlarged filtration.)
Let us now consider expectation of a random variable X conditional on these

information sets. The Law of Iterated Expectations says that

E X Ft = E E X Gt Ft
(2)
4 See among others, Samuelson (1965) and Black (1971).
5 See LeRoy (1989) for a literature review of the argument.

The Law of Iterated Expectations: Continued
In other words, if one has limited information Ft, the best forecast one can make of a
random variable X is the forecast of the forecast one would make of X if one had
superior information Gt . The expression (2) can rewritten as

E X − E X Gt Ft = 0, (3)
which has an intuitive interpretation that one cannot use limited information Ft to
predict the forecast error one would make if one had superior information Gt .
Suppose that a security price at time t, Pt, can be written as the rational expectation
of some ”fundamental value” V ⋆, conditional on information Ft available at time t,
⋆
Pt = E V Ft .
The same reasoning applies to the security price Ps at time s > t, that is
⋆
Ps = E V Fs .

The Law of Iterated Expectations: Continued

As Ft ⊂ Fs , for all t < s, the expectation of the price change Ps − Pt over the
interval [t, s) is therefore given following the Law of Iterated Expectation (2) by

E Ps − Pt Ft = E Ps Ft − Pt

⋆
= E E V Fs Ft − Pt
⋆
= E V Ft − Pt
= Pt − Pt
= 0.
Thus, realized changes in prices are unforecastable given information set Ft . From this
relatively elementary exercise we deduce martingale property of security prices:

E Ps Ft = Pt.
The essential passage behind the martingale concept is the notion of a fair game, a
game which is neither in the favor of an investor nor his/her opponent’s.
Alternatively, a game is fair if the expected incremental investment wealth at any

stage is zero when conditioned on the history of the game.

Asset Dynamics: The Random Walk Hypothesis
The notion of martingale has become a powerful tool and important applications
modern theories of asset prices - it has revolutionized the pricing of complex financial
instruments such as fixed income, options, swaps, and other derivative securities.
Needless to say, the martingale has become an integral part of every scientific
discipline concerning with asset model of asset prices: the random walk hypothesis.
1. The Random Walk I: IID Increments
The simplest version of the RW hypothesis is the IID increments case
2
Pt = µ + Pt−1 + ǫt, where ǫt ∼ IID(0, σ ), (4)
where µ is the expected price change or drift, and IID(0, σ 2) denotes that ǫt is
independently and identically distributed with mean 0 and variance σ 2.

Exercise Conditional on P0 , show that

E Pt P0 = P0 + µt
2
(5)
Var Pt P0 = σ t.
It is apparent from (5) that the RW (4) is nonstationary and conditional mean and
variance are both linear in time.
Remarks The independence of the increments of {ǫt} implies that the random
walk is also a fair game, but in a much stronger sense than the martingale:
Independence implies not only that increments are uncorrelated, but that any
nonlinear functions of the increments are also uncorrelated.
Perhaps the most common distributional assumption for the innovations or increments
ǫt is normality. If ǫt ’s are IID N (0, σ 2), then (4) is equivalent to an arithmetric
Brownian motion, sampled at regularly spaced unit intervals.
This distributional assumption simplifies many calculations, but violates the limited
liability condition: the price must be nonnegative. (If the conditional distribution of Pt
is normal, then there will always be a positive probability that Pt < 0.)

However, when natural logarithm of prices pt := log Pt follows a random walk with
normally distributed increments ǫt, i.e.,
2
pt = µ + pt−1 + ǫt , ǫt are IID N (0, σ ),
the returns pt’s follow the lognormal model of Bachelier (1900) and Einstein (1905).
2. The Random Walk II: Independent Increments
This model relaxes the assumptions of RW1 to include processes with independent but
identically distributed increments. An example of this type of process, consider
Pt = µ + Pt−1 + σt−1ǫt, where ǫt ∼ IID(0, 1), (6)
where σt accounts for the time-variation in volatility of the asset price Pt .

Capital Asset Pricing Model (CAPM)

The Economic Models of Asset Returns
The Economic model is a statistical model which gives the opportunity to calculate
more precise measures of the return of any given security using proper economic
indicators.
Assumption Let R be an (N × 1) vector of asset returns for calendar time period

t. Rt is independently multivariate normally distributed with mean µ and
covariance matrix Σ for all t.
1. Constant-Mean-Return Model
Let µi , the ith element of µ, be the mean return for asset i. The
constant-mean-return model is defined by
Rit = µi + ξit

where E ξit = 0 and Var ξit = σξ2 .
i
where Rit , the ith element of Rt , is the period-t return on security i, ξit is the
zero-mean disturbance term, and σξ2 is the (i, i) element of Σ.
i

2. Market Model
The model is a statistical model which relates the return of any given security to the
return of the market portfolio. For any security i, the model is specified by
Rit = αi +βi Rmt + ξit

2
where E ξit = 0 and Var ξit = σξ .
i
where
• Rit and Rmt are the period-t returns on security i and the market portfolio,
respectively,
• ξit is the zero-mean disturbance term,
• and αi , βi and σξ2 are the parameters of the market model.
i
In applications, a broad based stock index is used for the market portfolio, with the
S&P500 index, etc. (incl. CRSP value-weighted index, and the CRSP equal-weighted
index being popular choice.)

Statistical Estimation of the Economic Models
Recall the market model for security i and observation time τ
Riτ = αi + βi Rmτ + ξiτ (7)
The estimation-window observations can be expressed as a regression system,
Ri = Xi θi + ξi (8)
where
• Ri = (Rit1 , ..., Ritl )′ is an (l × 1) vector of estimation-window returns,
• Xi = (1, Rm) is an (l × 2) matrix with a vector of ones in the first column

returns,
• Rm = (Rmt1 , ..., Rmtl )′ is the vector market return observations,
• and θi = (αi , βi )′ is the (2 × 1) parameter vector.

Under general conditions ordinary least squares (OLS) is a consistent estimation

procedure for the market-model parameters.
Statistical Estimation: Continued
The OLS estimators of the market-model parameters using an estimation window of l

observations are given by
′ −1 ′
θbi = (Xi Xi) XiRi
2 1 b′ b
σ
bξ = ξ ξi
i (l − 2) i
ξbi = Ri − Xi θbi
′ −1 2
Var θbi = (Xi Xi) σ bξ
i

Capital Asset Pricing Model

Markowitz (1959) laid the groundwork for the CAPM. Sharpe (1964) and Lintner
(1965) improved the Markowitz model to develop economy-wide implications.
• The Sharpe and Lintner derivations of the CAPM assume the existence of lending
and borrowing at a risk-free rate of interest. The Sharpe and Lintner’s CAPM model is

E Ri = Rf + βim E Rm − Rf (9)

hRi, Rmi Cov Ri , Rm
βim = := (10)
hRm, Rmi Var Rm
Define Zi := Ri − Rf . Then, for the Sharpe and Lintner’s CAPM model we have

E Zi = βimE Zm
hZi , Zm i
βim = (11)
hZm, Zmi
where Zm := Rm − Rf is the excess return on the market portfolio of assets.
In the case where the risk-free interest rate Rf is nonstochastic6 (10) = (11).
6 implying that hR , R i = 0.
i f

Capital Asset Pricing Model: Continued
In the absence of riskfree asset, Black (1972) derived a more general version of CAPM,
known as the Black version. In this version, the expected return of asset i in excess of
the zero-beta return is linearly related to its beta. Specifically, the model is given by

E Ri = E Rom + βim E Rm − E Rom ,
where Rom is the return on the zero-beta portfolio 7 associated with market portfolio
m. The analysis of the Black version of CAPM treats the zero-beta portfolio return as
unobserved quantity, making the analysis more complicated than the Sharpe-Lintner.
For the Black model, returns are generally stated on an inflation-adjusted basis. The
model can be tested as a restriction on the real-return market model, i.e.,

E Ri = αim + βimE Rm
hRi , Rmi
βim =
hRm, Rmi

αim = E Rom 1 − βim
7 This portfolio is defined to be the portfolio that has the minimum variance of all portfolios uncorrelated with m. (Any
other uncorrelated portfolio would have the same expected return, but a higher variance.)

Assumptions underlying the CAPM model
• investors behave so as to maximize the expected utility of their wealth at the end
of a single period.
• investors choose among alternative portfolios according to expected return and
variance (or standard deviation) in return
• borrowing and lending are unlimited and take place at an exogeneously determined
risk-free rate.
• all investors share identical subjective estimates of the means, variances, and
covariances of return of all assets.
• assets are completely divisible and perfectly liquid, with no transactions costs
incurred in their purchase or sale.
• all investors are priced takers8, there are no taxes, and the quantities of all assets
are fixed.
8 in a perfectly competitive market, no individual’s decisions to buy or sell will affect the market price; hence, individuals
must simply accept the market price when they trade.

The CAPM is a single-period model; there is no time dimension involves in the

dynamics of asset returns. Consider a portfolio of N risky assets whose value is given
by
XN
p j j ′ ′
R = xp R := xp R, with xp 1 = 1.
j=1
Technical assumptions
• Assume that returns are IID through time and jointly multivariate normal.
• The expected returns of at least two assets differ

• The covariance matrix Σ := E RR′ is of full rank - invertible.
′

Denote µ := E R and Σ := E RR . Portfolio p has mean return and variance
µp := xp′ µ and variance σp2 = xp ′Σxp
The covariance hRp, Rq i between any two portfolios p and q is given by
hRp, Rq i = xp′Σxq .

Definition 2. Portfolio p is the minimum-variance portfolio of all portfolios with

mean return µp if weights vector xp is the solution to the CO problem:
′
x µ = µp
min x′ Σx, subject to (12)
x x′1 = 1
To solve the problem, let us consider the Lagrangian function:

′ ′ ′
L(x, λ1, λ2) := x Σx + λ1 µp − x µ + λ2 1 − x 1
The first order Euler condition gives us the following system of equations
2Σx − λ1µ − λ21 = 0 (13)

′
xµ = µp (14)
′
x1 = 1 (15)
By multiplying the equation (13) both side by Σ−1 we get

1 −1 1 −1
x= λ1 Σ µ + λ2Σ 1. (16)
2 2

CAPM with Risk-Free Asset
By imposing the conditions (14) and (15), we have
1 ′ −1 1 ′ −1
1 Σ µ λ1 + 1 Σ 1 λ2 =1
2 2
(17)
1 ′ −1 1 ′ −1
µ Σ µ λ1 + µ Σ 1 λ2 =µp .
2 2
Now let us define the constants: A = 1′Σ−1µ, B = µ′Σ−1µ, C = 1′ Σ−11, and

D = BC − A2. Solving the equations (17) for λ1 and λ2 , we obtain from (16):
xp = g + hµp,
where g and h are (N × 1)−vectors defined by
1 −1 −1
g = BΣ 1 − AΣ µ
D
1 −1 −1
h = CΣ µ − AΣ 1 ,
D

CAPM with No Risk-Free Asset
Figure 2: Minimum-Variance Portfolios Without Risk-free Asset.
g is the minimum variance portfolio. op is the zero-beta portfolio w.r.t the portfolio
p, as this portfolio has a zero covariance with the portfolio p, i.e., hRop, Rpi = 0.

Let Rf be the return of risk-free asset. The portfolio optimization amounts to solving
′
min x′Σx, ′
subject to x µ + 1 − x 1 Rf = µp (18)
x
The corresponding Lagrangian function is defined by

′ ′ ′
L(x, λ) := x Σx + λ µp − x µ − 1 − x 1 Rf .
Differentiating L w.r.t x and λ, we obtain

2Σx − λ µ − Rf 1 = 0 (19)
′ ′
x µ + 1 − x 1 Rf = µp (20)
Notice that the equation (20) can be rewritten as

µp − Rf = x′ µ − Rf 1 . (21)

Multiplying both sides of (19) by Σ−1 to get
1 −1
x= Σ λ µ − Rf 1 . (22)
2
By inserting x (22) in (21), we get
(µp − Rf ) −1
λ= Σ µ − Rf 1 ,
(µ − Rf 1)
from which we finally have
(µp − Rf )
xp = Σ−1 µ − Rf 1 .
(µ − Rf 1)Σ−1 µ − Rf 1
Note that we can express xp as a scalar which depends on the mean of p times a
portfolio weight vector which does not depend on p, i.e.,
xp = Cpb
x.

CAPM with No Risk-Free Asset
Figure 3: Minimum-Variance Portfolios Wit Risk-free Asset.
With a risk-free asset, all efficient portfolios lie along the line from the risk-free asset
to the tangency portfolio, whose slope measures the market price of risk. The
tangency portfolio can be characterized as the portfolio with the maximum Sharpe
ratio of all portfolios of risky assets.

Thus, with a risk-free asset all minimum-variance portfolios are a combination of a

given risky asset portfolio with weights proportional to b
x and the risk-free asset.
This portfolio of risky assets is called the tangency portfolio and has weight vector
−1

Σ µ − Rf 1
xq = ′ −1 . (23)
1Σ µ − Rf 1
With a risk-free asset, all efficient portfolios lie along the line from the risk-free asset
to the tangency portfolio, whose slope measures the market price of risk.
The tangency portfolio can be characterized as the portfolio with the maximum
Sharpe ratio of all portfolios of risky assets.
In the next section below we will derive the Sharpe-Lintner CAPM model (9).

The Sharpe-Lintner CAPM model
The model can be derived as follows. Replace x by the tangency portfolio xq (23) in
the equation (20) so that 1′ xq = 1 and multiply xm to both sides to get
′
2xmΣxm = λxm µ − Rf 1 = λ µm − Rf
from which we obtain

1 µm − Rf 1 µm − Rf 1
= = .
λ 2x′mΣxm 2
2σm
Substituting back to the equation (20), we have

µm − Rf 1
µ − Rf 1 = 2
Σxm.
σm
More specifically in terms of individual asset i, for i = 1, 2, ..., N , we have
σip
µi − Rf = 2 Rm − Rf = βi Rm − Rf .
σm

Fixed Income Analysis :

Discrete-Time Framework

The Basic Theory of Interest Rate

• Simple Interest rate: The general rule is that
• If an amount A (referred to as principal) is left in account at simple interest y , the value after n
years is V = (1 + yn)A.
• If the proportional rule holds for fractional years, then after any time t (measured in years), the
account value is V = (1 + yt)A.
• Compound Interest rate

• Compounding at various intervals The general method is that a year is divided into a fixed
number of equally spaced periods - say m periods. The interest rate for each of the m periods is
y y mt
thus m . Then after any time t (measured in years), the account value is (1 + m ) .
• Continuous compounding To determine the yearly effect of continuous compounding, we use of
y mt
the fact that limm→∞(1 + m ) = eyt .
• Debt: money borrowed from the bank will grow according to the same formulas.
• Money market In reality there are many different rates9 each day applied to
different circumstances, different user classes, and different periods.
• Examples: US Treasury bills and notes, LIBOR rate, Mortgage rate, inflation rate, etc.
9 Most rates are established by the forces of supply and demand in broad market to which they apply

Net Present and Future Values of Streams
Definition 3. [Future value of a stream] Given a cash flow stream (x0 , x1 , ..., xn)
and interest rate r each period, the future value of the stream is defined by
n n−1
FV = x0 (1 + y) + x1 (1 + y) + ... + xn
.Example Consider the cash flow stream (−2, 1, 1, 1) when the periods are years and
the interest rate is 10%. The future value is given by
3 2
FV = −2 × (1.1) + 1 × (1.1) + 1 × (1.1) + 1 = +0.648
.
Definition 4. [Net present value of a stream] Given a cash flow stream
(x0 , x1 , ..., xn ) and interest rate y each period, the present value of this stream is
x1 x2 xn
PV = x0 + + 2
+ ... + n
.
1+y (1 + y) (1 + y)
Example Consider the cash flow stream (−2, 1, 1, 1). Using an interest rate of 10%,
1 1 1
PV = −2 + + + = +0.487.
1.1 (1.1)2 (1.1)3

Internal Rate of Return
The concept pertains especially to the entire cash flow streams associated with an
investment. The streams to which the concept is applied typically have both negative
elements (payments that must be made) and positive elements (payments received).
• [Main theorem of internal rate of return] 10]. Let (x0 , x1 , ..., xn ) be cash flow
stream with x0 < 0 and xk ≥ 0 for all k, k = 1, 2, ..., n, with at least one term
being strictly positive. Suppose that there exist an internal rate of return y ⋆
satisfying 1/(1 + y ⋆) = c⋆. Then, it can be shown that c⋆ solves uniquely
2 n
0 = x0 + x1 c + x2c + ... + xnc . (24)
Pn
Furthermore, if k=0 xk > 0 (the total amount returned exceeds the initial
investment), then the internal rate of return y ⋆ = 1/c⋆ − 1 is strictly positive.
• See equation (??) for further numerical discussion on solving equation (24).
10 See page 24 of Luenberger [4]

Applications and Extensions
• Cycle Problems. When using interest rate theory to evaluate ongoing (repeatable)
activities, it is essential that alternatives be compared over the same time horizon.
• Net Flows. In conducting a cash flow analysis using either NPV or IRR, it is
essential that the net of income minus expenses be used as the cash flow each period.
• The net profit usually can be found in a straightforward manner, but the process can be subtle in
complex situations, e.g., certain tax-accounting costs and profits are not always equal to actual cash
outflows or inflows.
• Taxes. If a uniform tax rate were applied to all revenues and expenses as taxes and
credits, respectively, then recommendations from before-tax and after-taxes analyses
would be identical.
• Inflation is another economic factor that causes confusions, arising from the choice
between using actual dollar values to describe cash flows and using values expressed in
purchasing power, determined by reducing inflated future dollar values back to a
nominal level.

Inflation: Continued
• Inflation is characterized by an increase in general prices in time. Inflation can be

described quantitatively in terms of an inflation rate f . Inflation compounds
much like interest does. So, after n years of inflation at rate f , prices will be
(1 + f )n times their original values.
• Another way to look at inflation is that it erodes the purchasing power of money.
A dollar today does not purchase as much bread or milk as a dollar did ten years
ago. If the inflation rate is f , then the value of a dollar next year in terms of
purchasing power of today’s dollar is 1/(1 + f ).
• In reality, inflation rates do not remain constant, but may fluctuate randomly.
• we define a new interest rate, termed the real interest rate r0, which is the rate at
which real dollars increase if left in a bank that pays the nominal interest rate r .
• If one dollar is left in a bank for a year, it will increase nominally by (1 + r) at

the end of the year, but its purchasing power is deflated by 1/(1 + f ). So the
1+r
real value of the dollar is given by 1 + r0 = 1+f .
r−f
• Solving the above equation for r0, we arrive at r0 = 1+f .

Bonds and Forward Rates

This part of the course is aimed at providing answer to the question like what is the
sixth-month interest rate that the market expects to prevail two years in the future?
Definition 5. [Zero-coupon bond] A zero-coupon bond with maturity date T , also

called T −bond, is a contract which guarantees the holder $1 to be paid on date T .
The price at time t of a T −bond is denoted by P (t, T ).
• We denote by P (t) the value at time zero of t−bond, i.e., P (t) := P (0, t).
• We impose the following assumption:
• There exists a (frictionless) market for T −bonds for every T > 0.

• The relation P (t, t) = 1 holds for all t.
• For each fixed t, the bond price P (t, T ) is differentiable w.r.t T .
[Remarks]
• For a fixed value of t, P (t, T ) (as a function of T ) is a very smooth graph11.

• For a fixed value of T , P (t, T ) (as a function of t) is a random process.
11 also called the term structure at time t.

What is forward rate?

Suppose that at time t I decide to write a financial contract which allows me to make
a $1 investment at time S > t at a deterministic rate of return L over a period of
time [S, T ] in the future. The rate of return is determined at current time t.
How can I replicate this contract?
• Borrow one unit of S−bond at time t and sell it to get $P (t, S).
• Use the $P (t, S) cash to buy at time t P (t, S)/P (t, T ) units of T −bonds.
• At time S , the S−bond matures, so we have to pay back $1 at time S .
• At time T , the T −bonds mature and worth $P (t, S)/P (t, T ).
• Based on the financial contract written at time t, $1 investment at time S will
give me $P (t, S)/P (t, T ) at time T .
• Thus, at time t we have made a contract which guarantees a riskless rate of
interest L over the future interval [S, T ]. Such an interest is called a forward rate.
• So, the simple forward rate L satisfies the relation:
P (t, S) R(T −S) P (t, S)
1 + (T − S)L = or e = .
P (t, T ) P (t, T )

Varieties of Interest Rates in Fixed Income

Definition 6.
• Simple forward rate (LIBOR rate) for [S, T ] contracted at time t is defined as
P (t, T ) − P (t, S)
L(t; S, T ) = − .
(T − S)P (t, T )
• Simple spot rate (LIBOR spot rate) for the period [S, T ] is defined as
P (S, T ) − 1
L(S, T ) = − . (25)
(T − S)P (S, T )
• Continuously compounded forward rate for [S, T ] is defined as
log P (t, T ) − log P (t, S)
R(t; S, T ) = − .
(T − S)
• Continuously compounded spot rate for the period [S, T ] is defined as
log P (S, T )
R(S, T ) = − .
(T − S)
• Instantaneous forward rate with maturity T contracted at time t is defined as
∂ log P (t, T )
f (t, T ) = − . (26)
∂T
• Instantaneous short rate at time t is defined as r(t) = f (t, t).

Term Structure Curve Smoothing
• We already know that for a fixed t, T 7→ P (t, T ) is a very smooth function.
• Problem Find a smooth curve g that fits the term structure f (t) := f (0, t), for 0 ≤ t ≤ T , of
forward rates that satisfies a maximum smoothness criterion defined by
Z T
f ′′2 (u)du. (27)
0
subject to the constraints:

Z t
i
f (u)du = − log Pi , for i = 1, 2, ..., m, (28)
0
where Pi = P (ti), for i = 1, 2, ..., m, with P0 = 1, are given prices of discount bonds with
maturities 0 < t1 < t2 < ... < tm < T .
• Using the Lagrange multipliers method, solution to the problem (27)-(28) is that
2 3 4
f (t) = ai + bi t + ci t + di t + ei t , ti−1 < t ≤ ti , i = 1, 2, ..., m + 1
where the coefficients ai , bi , ci , di, ei are such that the functionsf, f ′ , f ′′ , f ′′′ are continuous at
Rt P
each knot points tj , j = 1, ..., m, and t i f (u)du = − log P i , i = 1, 2, ..., m
i−1 i−1

Duration and Convexity

Duration measures the sensitivity of cash flow to parallel shift of the yield curve12.
For continuously compounded yield, the PV of streams X is given by

n
X n
X
PV = P (ti )X(ti ) = e−y(ti )ti X(ti ).
i=1 i=1
As the yield curve y(t) makes parallel shift of amount y for each t, i.e.,
ynew(t) = y(t) + y , the PV changes accordingly to
X n X n
∂P V −y(ti )ti
=− ti e X(ti ) = − ti P (ti )X(ti ).
∂y i=1 i=1
Macaulay duration13 DX (of flows X )defined as the percentage change of PV, i.e.,
Pn
1 ∂P V ti P (ti )X(ti )
DX = − = Pi=1 n . (29)
PV ∂y i=1 P (ti )X(ti )
Hence, Duration can also be seen as the PV-weighted average of time to maturity.
12 referring to the 1930 work of Macaulay.
13 Also known as the Fisher-Weil duration.

Examples of Duration
Consider a three-year 10% coupon bond with a face value of $100. Suppose that the
yield on the bond is 12% per annum with continuous compounding. This means that
y = −0.12. Coupon payments of $5 are made every six months.
 
Time (yrs) Payment ($) Present Value Weight Time × Weight
 0.5 5 4.709 0.05 0.025 
 
 1.0 5 4.435 0.047 0.047 
 
 
 1.5 5 4.176 0.044 0.066 
 
 2.0 5 3.933 0.042 0.084 
 
 2.5 5 3.704 0.039 0.098 
 
 3.0 105 73.256 0.778 2.334 
Total 130 94.213 1.00 2.654
Following equation (29), we have that ∆P = −DP P ∆y = −2.654 × 94.213∆y ,

that is, ∆P = −250.04∆y . If ∆y = +0.001 so that the yield increases to
12.1%, we expect that the bond price to go down to 94.213 − 0.250 = 93.963.

Examples of Duration: Continued
Case Study A firm X is subject to paying an obligation of 1$ million in 10 years. The

firm is interested in finding an alternative investment that would meet its obligation.
The purchase of a zero-coupon bond would provide one of the solution. However,
zero-coupon bonds are not always available for the desired maturity. Alternatively, the
firm may invest in corporate bonds having the same yield of 9%
 
Security Maturity Price Yield Duration
 
 Bond 1 30 69.04 9% 11.44 
 
 Bond 2 10 113.01 9% 6.54 
Bond 3 20 100.00 9% 9.61
• Investment on Bonds 2 and 3 would create a serious problem as any positive

weighted average of D2 and D3 will be less than the required duration 10 years.
A bond with a longer duration is required. So, the firm decides to use bonds 1 and 2.

Examples of Duration: Continued
• The immunized portfolio is found by solving the equation:
V1 + V2 = P Vobligation
(30)
D1 V1 + D2V2 = 10P Vobligation
[Remarks]
• The first equation states that the total value of the portfolio must equal the total
present value of the obligation.
• The second equation states that the duration of the portfolio must equal the
duration (10 years) of the obligation.
The solution to the equation (30) is given by
V1 = $292.788, 73 and V2 = $121, 854.27.

Duration-Based Hedging Strategies
Consider a portfolio W consisting of an underlying security with PV X1 and a θ units

of hedging instrument with PV X2. The total value of this portfolio is given by
W = X1 + θX2.
The changes of the hedging portfolio to the parallel shift in the term structure of
interest rate can be written in terms of duration of each security as
∂W ∂X1 ∂X2
= X1 + θX2 = −X1 DX1 − θX2DX2 ,
∂y X1 ∂y X2∂y
from which the amount of the hedging instruments to hold is given by
X1 DX1
θ=− , (31)
X2 DX2
which makes the duration of the entire position zero.
This is called the duration-based hedge ratio, or price sensitivity hedge ratio.

Discrete Compounded Macaulay Duration
Suppose that the discount factors (P (ti ), i = 1, 2, ..., n are replaced by the one
that has the same interest rate (yield to maturity) at each maturity, i.e.,
1
P (ti ) = ,
[1 + (y/m)]i−1+x
where the time ti is directly calculated as ti = i−1+x

m . Using this formulation, the
conventional duration for bond with a dollar coupon C and discrete compounding
yield to maturity y is defined as
Pn
C i=1 ti P (ti ) + tn P (tn )F
Conventional Duration = −
Present Value
n
1 n h X (i − 1 + x) 1 i
= C
PV m [1 + (y/m)]i−1+x
i=1
(n − 1 + x) F o
+
m [1 + (y/m)]n−1+x
However, the formula doesn’t measure the percentage change in PV for a small
change in the discrete yield to maturity, as explained further on the next page.

Modified Duration
Notice that the Macaulay duration is based on continuously compounded yield.

What happens to the percentage change in PV when the discrete yield to maturity
shifts from y to y + z for infinitely small changes in z ? Simple derivative of (??) gives
1 ∂P V
Modified Duration = −
PV ∂y
n
1 n h X (k − 1 + x) 1 i
= C
PV m [1 + (y/m)]k+x
k=1
(n − 1 + x) 1 o
+
m [1 + (y/m)]n+x
Conventional Duration
= .
1 + (y/m)
• The two formulas are the same for continuous compounding yield.
• In terms of the hedge ratio, see eqn. (31), the modified duration may induce hedging
error if the bond to be hedged and the hedging instrument have different amounts of
accrued interest. This impact is known as the accrued interest rate effect.
• The impact is obviously most significant when the yield curve has a significant slope.

Limitations of Duration : Convexity measure
• The duration only measures the linear relationship between the percentage change
∆P/P in present value and change ∆y in yield of a bond portfolio.
Figure 4: Bonds X and Y with different convexity.
• For large yield changes, the portfolio may behave differently as the relationship may
not be linear. A factor known as convexity measures this curvature and can therefore
be used to improve the relationship in (29).

• For a continuously compounded, a measure of convexity is defined by
Pn 2
1 ∂ 2P V ti P (ti )X(ti )
CX = 2
= Pi=1
n . (32)
PV ∂y i=1 P (ti )X(ti )
• Using Taylor series expansions, we find
dP 1 d2 P 2
∆P = ∆y + (∆y)
dy 2 dy 2
1
= − DP ∆y + CP (∆y)2 .
2
By matching convexity as well as duration, a portfolio can be made immune to

relatively large parallel shifts in the curve. However, it is exposed to nonparallel shifts.

Yield-to-Maturity and Forward Rates
What is Yield-to-Maturity?
The yield to maturity of a bond is a discount rate which equates the PV of the bond’s
payments to its price. Thus if Pnt is the time t price of a discount bond that makes a
single payment of $1 at time t + n, and Ynt is the bond’s YTM, we then have
1
Pn,t = , (33)
(1 + Yn,t )n
or, equivalently, we can express YTM in terms of the bond price as

−1/n
(1 + Yn,t) = Pn,t . (34)
Taking the natural algorithm on both sides of the above equation, we have
1
yn,t = − pn,t . (35)
n
The term structure of interest rates is the set of YTMs, at a given time, on bonds of
different maturities. The yield curve is a plot of the term structure, that is the plot of
Yn,t or yn,t against n on some particular date t.

Yield-to-Maturity
18
16
14
Annualized percentage points ← 10−year yield
12
10
4 ← 1−month yield
0
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995
Figure 5: Short-and Long-Term Interest Rates 1952 to 1991.

Holding-Period Returns
The holding-period return on a bond is the return over some holding period less than
the bond’s maturity. Define Rn,t+1 as the one-period holding-period return on an
n−period bond purchased at time t and sold at time t + 1, i.e.,
Pn−1,t+1 (1 + Yn,t)n
(1 + Rn,t+1 ) = = . (36)
Pn,t (1 + Yn−1,t+1 )n−1
Remarks The holding period-return (36) is high if the bond has a high yield when it is
purchased at time t, and if it has a low yield when it is sold at time t + 1.
Taking the logs, the log holding-period return, rn,t+1 := log(1 + Rn,t+1 ), is given by
rn,t+1 = pn−1,t+1 − pn,t (37)

= nyn,t − (n − 1)yn−1,t+1

= yn,t − (n − 1) yn−1,t+1 − yn,t . (38)
Following (37), we obtain a relation between log bond prices and log holding-period

P n−1
return as pn,t = i=0 rn−i,t+1+i ., or in terms of the yield:
n−1
1X
yn,t = rn−i,t+1+i,
n i=0
showing that the log YTM on a zero-coupon bond equals the average log return per
period if the bond is held to maturity.
Forward Rates
The forward rate is defined to be the return on the time t + n investment of

Pn+1,t/Pn,t , i.e.,
1 (1 + Yn+1,t )n+1
(1 + Fn,t) = = n
.
(Pn+1,t /Pn,t ) (1 + Yn,t )
Moving to the logs scale, the n−period ahead log forward rate is
fn,t = pn,t − pn+1,t

= yn+1,t + n(yn+1,t − yn,t)
= yn,t + (n + 1)(yn+1,t − yn,t). (39)

Term Structure Models

All the models start from the general asset pricing martingale condition (??)14:

Pn,t = EQt P n−1,t+1 = E t Lt+1 n−1,t+1 .
P (40)
where the stochastic process Lt , known as the stochastic discount factor for
transforming the pricing kernel from P to Q, is defined by
dQ
Lt := and has the property that E Lt = 1.
dP Ft
The equation (40) lends itself to the recursive equation for the n−period ZC bond:

Pn,t = Et Lt+1 . . . Lt+n .
Assumption: We assume that the distribution of the stochastic discount factor L is

conditionally lognormal, and that bond prices are jointly lognormal with L, i.e.,
1
Et Lt Pn,t = exp Et lt + pn,t + Vart lt + pn,t . (41)
2
14 we have used the notation EQ Pn−1,t+1 := EQ Pn−1,t+1 F .

t Pn,t Pn,t t

Term Structure Models: Continued
Following (40), we obtain a recursive equation for bond prices:
1
pn,t = Et lt+1 + pn−1,t+1 + Vart lt+1 + pn−1,t+1 , (42)
2
Affine Term Structure Models
To get a general expression for the bond price, we guess that it is of the form
−pn,t = An + Bnxt (43)
for all n = 0, 1, . . . . Since the n−period bond yield yn,t = −pn,t/n, we are
guessing that the yield on a bond of any maturity is linear or affine in xt .
We already know that the bond price for n = 0 and n = 1 satisfy the equation (43),
with A0 = B0 = 0, A1 = −β 2 σ 2/2, and B1 = 1. We proceed with our guess using
the induction methodology- showing that it is consistent with the pricing relation (42).

Single-Factor Term Structure Model
As the stochastic discount factor Lt is defined in Ft, we assume that the variation of
the process L could be explained by some macro factors xt modeled by
−lt+1 = xt + ǫt+1 , (44)
with ǫt+1 being an innovation process normally distributed with constant variance.
The model is a discrete-time version of the Vasicek single-factor term structure model.
The model assumes that the macro factors xt evolves according to a univariate AR(1)
process with mean µ and persistence φ15,
xt+1 = (1 − φ)µ + φxt + ξt+1 . (45)
The innovations ǫt+1 may be correlated with ξt+1 . To capture this, we can write
ǫt+1 = βξt+1 + ηt+1 ,
where ξt+1 and ηt+1 are normally distributed with constant variances and are
uncorrelated with each other.
15 If φ = 1 the process is a unit root process.

Single-Factor Term Structure Model: Continued
The presence of the uncorrelated shock ηt+1 only affects the average level of the term
structure and not its average slope or its time series behavior.
To simplify the notation, we accordingly drop it and assume that
ǫt+1 = βξt+1 .
The equation (44) can therefore be rewritten as
−lt+1 = xt + βξt+1 . (46)
The innovation ξt+1 is now the only shock in the system.
Equations (46) and (45) imply that −lt+1 can be written as an ARMA(1,1) process as
it is a sum of an AR(1) process and white noise.

We can determine the price of a one-period bond by noting that
when n = 1, pn−1,t+1 = p0,t+1 = 0
so that the term pn−1,t+1 in (42) drop out. Substituting (46) and (45) into (42),
1 2 2
p1,t = Et lt+1 + Var lt+1 = −xt + β σ /2. (47)
2
The one-period bond yield y1,t = −p1,t can be written as
2 2
y1,t = xt − β σ /2.
Remarks:
The short rate equals the state variable less a constant term, so it inherits the AR(1)
dynamics of the state variable. So, we can think of the short rate as measuring the
state of the economy in this model. Notice that there is nothing in (47) that rules out
a negative short rate.

Our guess for the price function (43) implies that the two terms in (42) are given by

Et lt+1 + pn−1,t+1 = −xt − An−1 − Bn−1(1 − φ)µ − Bn−1φxt ,

Vart lt+1 + pn−1,t+1 = (β + Bn−1)2σ 2 . (48)
Substituting (43) and (48) into (42), we get
An + Bnxt − xt − An−1 − Bn−1(1 − φ)µ − Bn−1φxt

1
+ (β + Bn−1)2 σ 2 = 0.
2
As this must hold for any xt , so the coefficients on xt must sum to zero and the
remaining coefficients must also sum to zero. This implies that
(1 − φn)
Bn = 1 + φBn−1 =
(1 − φ)
1 2 2
An = An−1 + (1 − φ)µBn−1 − σ (β + Bn−1) , (49)
2
with A0 = B0 = 0, A1 = −β 2 σ 2/2, and B1 = 1.

Heteroskedastic Single-Factor Term Structure Model
The Vasicek model discussed previously is a homoskedastic model. Apart from its
appealing simplicity, the model has several unattractive features.
• First, it assumes that interest changes have constant variance.
• Secondly, the model allows interest rates to be negative. Given these, the model is
applicable to real interest rates, but less appropriate for nominal interest rates.
• Thirdly, the model implies that the the ratio of the expected excess return on a bond
to the variance is constant over time.
In order to handle these problems, while retaining the simplicity of the basic structure
and tractability of the model, one can alter the model by allowing the state variable xt
to follow a conditionally lognormal but heteroskedastic square-root process.
The heteroskedastic square-root model is a discrete-time version of the Cox, Ingersoll,

and Ross (1985) continuous-time model, replaces (46) and (45) with
√ √
−lt+1 = xt + xt ǫt+1 = xt + xt βξt+1 (50)
√
xt+1 = (1 − φ)µ + φxt + xt ξt+1 . (51)

Heteroskedastic Single-Factor Term Structure Model: Continued

√
The new term appearing in the model is that the shock ξt+1 is multiplied by xt .
Proceeding with the recursive analysis as before, we can determine the price of a
one-period bond by substituting (50) into (42) to get
1 2 2
p1,t = Et lt+1 + Vart lt+1 = −xt 1 − β σ /2 . (52)
2
As we can see, the one-period bond yield y1,t = −p1,t is proportional to the state
variable xt ; the short rate measures the state of the economy in the model.
Since the short rate is proportional to the state variable, it inherits the property that
its conditional variance is proportional to its level16. As a result, interest rate volatility
tends to be higher when interest rates are high.
This property makes it difficult for the interest rate to go negative, since the upward
drift in the state variable tends to dominate the shocks as xt declines towards zero.
16 implying the risk premia to be time-varying.

Heteroskedastic Single-Factor Term Structure Model: Continued
The price function for n−period bond has the same linear form as before:
−pn,t = An + Bnxt
with A0 = B0 = 0, A1 = 0, and B1 = 1 − β 2 σ 2 /2.
It is straightforward to show that

2 2
Bn = 1 + φBn−1 − (β + Bn−1) σ /2,
An = An−1 + (1 − φ)µBn−1. (53)
Remarks:
Comparing (53) to (49), we see that the term in σ 2 has been moved from the
equation describing An to the equation describing Bn. This is due to the fact that
the variance is now proportional to the state variable, so that it affects the slope
coefficient rather than the intercept coefficient for the bond price. The slope
coefficient Bn is positive and increasing in n.

Two-Factor Term Structure Model
We have considered a single-factor model for term structure of interest rate. Such
models imply that the all bond returns are perfectly correlated. The model is a
discrete-time version of the model of Longstaff and Schwartz (1992). The model takes
the following form:
√
−lt+1 = x1,t + x2,t + x1,t ǫt+1. (54)
We notice that the model nests the single-factor model by setting x2,t = 0, but does
not nests the single-factor homoskedastic model. In this model, minus the log SDF is
forecast by two state variables x1,t and x2,t , whose dynamics are
√
x1,t+1 = (1 − φ1 )µ1 + φ1 x1,t + x1,t ξ1,t+1 (55)
√
x2,t+1 = (1 − φ2 )µ2 + φ2 x2,t + x2,t ξ2,t+1 . (56)
The relation between shocks is specified according to
ǫt+1 = βξ1,t+1
meaning that the variance of the innovation to the log SDF is proportional to the level
of x1,t . The log SDF is conditionally correlated with x1,t but not with x2,t .

Two-Factor Term Structure Model: Continued
The shocks ξ1,t+1 and ξ2,t+1 are uncorrelated with each other. We denote by σ12 for
the variance of ξ1,t+1 and σ22 for the variance of ξ2,t+1 .
Following the usual way, we find that the price of a one-period bond is given by
1
p1,t = Et lt+1 + Vart lt+1 (57)
2
2 2
= −x1,t − x2,t + x1,t β σ1 /2. (58)
We observe that the one-period bond yield y1,t = −p1,t is no longer proportional to
the state variable x1,t as it also depends on 2,t. Said differently, the short rate is no
longer sufficient to measure the state of the economy in this model.
As pointed out by Longstaff and Schwartz, the variance of the short rate is a different
linear combination of the two state variables:
2 2 2 2 2
Vart y1,t+1 = (1 − β σ1 /2) σ1 x1,t + σ2 x2,t .

Two-Factor Term Structure Model: Continued
The bond price is assumed to be an affine function of the two state variables, i.e.,
−pn,t = An + B1,nx1,t + B2,nx2,t , (59)
with A0 = B1,0 = B2,0 = 0, A1 = 0, B1,1 = 1 − σǫ2/2, and B2,1 = 1.
It is straightforward to show that An, B1,n, and B2,n satisfy the recursive equations:
2 2
B1,n = 1 + φ1 B1,n−1 − (β + B1,n−1) σ1 /2, (60)
2 2
B2,n = 1 + φ2 B2,n−1 − B2,n−1σ2 /2, (61)
An = An−1 + (1 − φ1)µ1 B1,n−1 + (1 − φ2)µ2 B2,n−1 (62)

Fitting Term Structure Models to Real Data
Comparing one and two−factor models
6.6
6.4
6.2
Mean Yield
5.8
5.6
two−factor model
5.4 one−factor model
bond yields data
10 20 30 40 50 60 70 80 90 100 110 120

Maturity in Months
Figure 6: Fitting single-factor and two-factor term structure models to real data.

Fixed Income Analysis :

Continuous-Time Framework

Term Structure Model of Interest Rate

In the previous lectures we have assumed through the concept of duration that interest
rate at all maturities move at the same direction - parallel shifts.
In contrast to this assumption, the interest rate in fact moves randomly in time.
[Term Structure Equation] We assume that there is a arbitrage-free market for

T −bonds for every choice of T and that the price of a T −bond
P (t, T ) := P (t, r(t); T ),
is a smooth function of the three variables with the maturity condition
P (T, r; T ) = 1.
[Short Rate Dynamics] We assume that the dynamics of short rate r(t) is driven by
the following stochastic differential equations (SDE):
dr(t) = µ(t, r(t))dt + σ(t, r(t))dB(t), (63)
where B is a standard Brownian motion having the following properties.

Standard Brownian motion (SBM)
Definition 7. [Standard Brownian motion] is a stochastic process with properties:
• For any t1 and t2 s.t. 0 ≤ t1 ≤ t2 ≤ T ,
B(t2 ) − B(t1 ) ∼ N (0, t2 − t1).
• For any t1, t2 , t3 , and t4 s.t. 0 ≤ t1 ≤ t2 ≤ t3 ≤ t4 ≤ T,
B(t2 ) − B(t1 ) is statistically independent of B(t4) − B(t3).
• The sample paths of B(t) are continuous.
Multiplication rules for stochastic differentials dB(t)

 
× dB(t) dt
 dB(t) dt 0  (64)
dt 0 0
If we have a stochastic differential equation (SDE):
dX(t) = µ(t, X(t))dt + σ(t, X(t))dB(t),

then due to the multiplication rule (64), we have

2 2
(dX(t))2 = µ2 (t, X(t)) dt + σ 2(t, X(t)) dB(t)

+ 2µ(t, X(t))σ(t, X(t)) dtdB(t)
= σ 2(t, X(t))(dB(t))2
2
= σ (t, X(t))dt.
Simulating Stochastic Differential Equations
Assume that we are given a stochastic differential equation (SDE) of the form
dX(t) = µ(t, X(t))dt + σ(t, X(t))dB(t).
We are interested in simulating the solution in discrete time. The most common
scheme and easiest way to implement is the so-called Euler scheme:
√
b b b
Xkh = X(k−1)h + µ (k − 1)h, X(k−1)h h + σ (k − 1)h, X(k−1)h b hNk ,
where Nk are IID N (0, 1) standard Gaussian random variable.

Ito’s formula
Theorem 1. [Itô’s Formula] Assume that the process X solves the following SDE
dX(t) = µ(t, X(t))dt + σ(t, X(t))dB(t).
Let F be a C 1,2 −smooth function. Define the process Z by
Z(t) = P (t, X(t)).
Then the process Z has the following SDE:

1 2
dP = Pt + µ(t, x)Px + σ (t, x)Pxx dt + σ(t, x)Px dB(t). (65)
2
[Heuristic proof] Applying the Taylor expansion including second order terms, we have
1 2 1 2
dP = Pt dt + PxdX + Pxx(dX) + Ptt (dt) + Ptx(dtdX).
2 2
The result in (65) is obtained after applying the multiplication rules (64).

Dynamics of T −bond
Consider a hedging portfolio V consisting of T −bond and S−bond, i.e.,

T S
V (t) = P (t) + θ(t)P (t). (66)
Assume that the hedging strategy θ(t) is predictable17, and the short rate r(t) follows
(63) so that by (65) the dynamics of the T −bond price P T (t, r) can be written as
dP T
= αT (t)dt + βT (t)dB(t), (67)
PT
1 2
T −1 T T T
αT (t) = (P ) Pt + µ(t, r)Pr + σ (t, r)Prr , (68)
2
T −1 T
βT (t) = σ(t, r)(P ) Pr . (69)
Likewise for S−bond. By inserting (67) and the corresponding equation for S−bond,
T S
dV (t) = αT (t)P (t) + θ(t)αS (t)P (t) dt
(70)
T S
+ βT (t)P (t) + θ(t)βS (t)P (t) dB(t).
17 that is to say θ(t) = θ(t + dt) - the hedging strategy for the period of time [t, t + dt) has been specified at time t.

In order to make the portfolio risk-neutral, the hedging strategy should be
βT (t)P T (t) PrT

θ(t) = − =− S for all t ≥ 0 (71)
βS (t)P S (t) Pr
By substituting this portfolio strategy back to the equation (70) gives

n α (t)β (t) − α (t)β (t) o
S T T S
dV (t) = V (t) dt.
(βT (t) − βS (t))
By applying the no arbitrage argument, we must have the condition
αS (t)βT (t) − αT (t)βS (t)
= r(t) for all t ≥ 0,
(βT (t) − βS (t))
with probability 1. Equivalently, we can rewrite the above equation as
αS (t) − r(t) αT (t) − r(t)

= for all t ≥ 0 . (72)
βS (t) βT (t)
Remark Notice that the two quotients are equal regardless of the choice of the bond18.
18 It is the fixed income equivalent of the Sharpe ratio.

The Market Price of Risk and Term Structure Equation
Proposition 1. If the bond market is free of arbitrage, then there exist a process λ
such that it holds true for all t ≥ 0 and every choice of maturity time T that
αT (t) − r(t)
= λ(t). (73)
βT (t)
Furthermore, by inserting the expressions (68) and (69) for αT and βT , respectively,
we obtain a so-called the term structure equation (TSE) given in the eqn. (74) below.
Proposition 2. Assume that the short rate evolves according to (63). If the bond
market is free of arbitrage, then the price of the T −bond P T solves the TSE:
1
PtT + µ − λσ PrT + σ 2Prr
T
− rP T = 0
2 (74)
P T (T, r) = 1.
In order to solve the term structure equation, we must specify the market price of risk
λ as well as the drift and µ and the volatility σ of the short rate (63).

Stochastic Representation Formula
The term structure equation (74) for which the T −bond price solves was derived
based on the construction of risk-neutral self-financing bonds portfolio and on the
assumption that the market is free of arbitrage. The equation is solvable once the
parameters of the short rate are specified and the market price of risk λ is given.
risk-neutral + no-arbitrage arguments ⇒ term structure equation.
Question Taking account the TSE (74) as a free-of-arbitrage market specified, what
would be the risk-neutral dynamics of the short rate r induced by that market?
Proposition 3. Assume that a free-of-arbitrage bond market specifies that the

T −bond price P (t, r; T ) solves the TSE (74). Then19,
R
Q − tT r(u)du
P (t, r; T ) = E e P (T, r; T ) Ft , (75)
where Q is a risk-neutral pricing measure under which the dynamics of short rate is
dr(t) = (µ − λσ)dt + σdB(t).

19 Here F is the market information of the short rate r(u) for u ≤ t.
t

Affine Term Structure Models
We are interested in finding a closed form solution to the TSE (74). We assume that
under the risk-neutral pricing measure Q the dynamics of the short rate r is given by
dr(t) = µ(t, r(t))dt + σ(t, r(t))dB(t).
Question Under which forms of µ and σ such that the T −bond price is of the form
F (t,T )−G(t,T )r(t)
P (t, r; T ) = e . (76)
Proposition 4. Assume that the drift µ and the volatility σ of r are of the form
µ(t, r) = α(t)r + β(t)

q (77)
σ(t, r) = γ(t)r + δ(t)
Then, the T −bond price has the form (76) where the functions F and G solve
1 2
Gt (t, T ) + α(t)G(t, T ) − γ(t)G (t, T ) = − 1, G(T, T ) = 0,
2
(78)
1
Ft(t, T ) − β(t)G(t, T ) + δ(t)G2 (t, T ), = 0, F (T, T ) = 0.
2

Merton Term Structure Model
In his famous 1970 paper, Merton proposed a simple model of short rate:
dr(t) = σdB(t). (79)
Following the TSE (74), the T −bond price solves the following equation:
1
Pt − λσPr + σ 2Prr − rP = 0, P (T, r; T ) = 1
2
After some tedious calculations, it turns out that the solution to this PDE is
−rτ +λστ 2/2+1/6σ 2aτ 3

P (t, r; T ) = P (τ, r) = e , τ = T − t.
r− Duration of coupon bearing bonds
Consider PV of streams (Xi , i = 1, 2, ..., n). Duration under Merton is

Pn
i=1 τi P (τi , r)Xi
Merton r− Duration = P n ,
i=1 P (τi , r)X i

Hedge ratio
The hedge ratio of the hedging portfolio is given by

(T − t)P (t, r; T )
θ=− .
(S − t)P (t, r; S)
Yield curve
For continuous compounding, the ZC bond yield implied by the model is

1 1 1 2 2
y(τ ) = − ln P (τ, r) = r − λστ − σ τ .
τ 2 6
Remarks
• The yield achieves its maximum value r + 38 λ2 at τ = − 2σ

3λ
.
q
2
• The yield equals zero at τ = − 2σ + σ λ4 + 2r
3λ 3
3.
• The yields become negative as time to maturity τ increases.
• The yield tends to be largely negative for long-maturity bond.

Extended Merton Model of Term Structure
Ho and Lee Model
The model introduces a deterministic drift to the Merton model (79):
dr(t) = θ(t)dt + σdB(t).
Solving the TSE (74) we arrive at

F (t,T )−G(t,T )r(t)
P (t, r; T ) = e , (80)
where the functions F and G are defined by

Z T
σ2 λσ
G(t, T ) = T − t and F (t, T ) = θ(s)(s − T )ds + (T − t)3 + (T − t)2 (81)
t 6 2
following which the yield to maturity implied is
Z
λσ σ2 1 T
y(t, T ) = r − (T − t) − (T − t)2 − θ(s)(s − T )ds. (82)
2 6 (T − t) t
The function θ(t) is chosen such that the theoretical zero-coupon bond prices at
t = 0 (P (0, T ); T ≥ 0) fits the observed initial term structure (P ⋆(0, T ); T ≥ 0).
We thus want to find θ(t) such that P (0, T ) = P ⋆(0, T ) for all T ≥ 0.

The Vasicek Term Structure Model
Short Rate
0.08
0.07
0.06
r(t)
0.05
0.04
0.03
0.02
0 2 4 6 8 10
Time
In his 1977 work, Vasicek proposed a model that avoids the certainty of having
negative yields in the Merton model of term structure, which is of the form
dr(t) = α(γ − r(t))dt + σdB(t). (83)

There are compelling economic arguments in favor of mean reversion:
• When rates are high, the economy tends to slow down as there is low demand for
fund from borrowers, which results in declining rates.
• When rates are low, there is a high demand for funds from borrowers, resulting
increasing in rates.
• When rates rise above the expected long-term rate γ , the rates is pulled back below
γ at the speed α, vice versa.
Exercise Show using Itô’s formula that solution to the Vasicek model (83) is
Z t
−αt −αt αu
r(t) = γ + e r0 − γ + σe e dB(u) . (84)
0
Following this solution, it is readily to see that

σ2
−αt −2αt
r(t) ∼ N γ + e (r0 − γ), 1−e . (85)
2α

The governing equation for the T − bond price is given by

1 2
Pt + α(γ − r) − λσ Pr + σ Prr − rP = 0, P (T, r; T ) = 1. (86)
2
Exercise Assume that solution to the equation (86) is of the form
P (τ, r) = eF (τ )−G(τ )r ,
where τ = T − t. By inserting this in (86), the functions f and g are found to be

1 −ατ

G(τ ) = 1−e
α
λσ σ2 σ 2G2 (τ )
F (τ ) = − γ + − 2
τ − G(τ ) − .
α 2α 4α
r− Duration of coupon bearing bonds
Consider PV of streams (Xi , i = 1, 2, ..., n). Duration under Vasicek is

Pn
i=1 G(τi )P (τi , r)Xi
Vasicek r− Duration = Pn .
i=1 P (τi , r)X i

Hedge ratio
The hedge ratio of the hedging portfolio is given by

G(T − t)P (t, r; T )
θ=− .
G(S − t)P (t, r; S)
Yield curve
For continuous compounding, the ZC bond yield implied by the model is
1 λσ σ2
y(τ ) = − f (τ ) + g(τ )r −→ y(∞) = γ +
|{z} − 2
.
τ as τ → ∞
α 2α
Remark
• The duration and hedge ratio under the Merton model can be seen as the limit of
the Vasicek model’s as the speed of mean reversion α tends to zero.
• The yield is positive at perpetual time, correcting one of major concern of the
Merton term structure model (79).
• Since the short rate r(t) is normally distributed, see equation (85), there is a
positive probability that the short rate r(t) can become negative.

Extended Vasicek Model of Term Structure
Hull and White Model
Hull and White (1990) proposed a model which improves the Vasicek model Under the
risk-neutral measure, the Hull and White model of short rate is defined as follows

dr(t) = θ(t) − ar(t) dt + σdB(t),
where a and σ are constants while θ(t) is a deterministic function of time.
The parameters a and σ are typically chosen to obtain a nice volatility structure,
whereas the function θ(t) is chosen such that the theoretical zero-coupon bond prices
at t = 0 (P (0, T ); T ≥ 0) fits the observed initial term structure (P ⋆(0, T );
T ≥ 0). We thus want to find θ(t) such that P (0, T ) = P ⋆(0, T ) for all T ≥ 0.
R
−G(t,T )r(t)+ tT 1 σ 2G2 (s,T )−θ(s)G(s,T ) ds
P (t, T ) = e 2 , (87)
where the function G(t, T ) is defined as

1 −a(T −t)
G(t, T ) = 1−e .
a

Alternative Term Structure Models
The aim is to review other alternative term structure models that exclude the
possibility of having negative short rate found in the Merton and Vasicek models.
One-factor interest rate models
• Cox-Ingersoll-Ross model The model is very influential in market practise

q
dr(t) = α γ − r(t) dt + σ r(t)dB(t).
This model also exhibits mean reverting behavior as Vasicek model does, causing
interset rate cycles. The distinct feature is that the model induces positive short rate.
CIR shows that the price of ZC bond is given by
P (τ, r) = eF (τ )−G(τ )r , (88)
where τ = T − t and the functions F and G are defined by

2βe(β+λ+α)τ /2
2αγ 2 1 − e−βτ
F (τ ) = ln , G(τ ) = − ,
σ2 H(τ ) H(τ )

where the function H and parameter β are defined by

βτ
H(τ ) = 2β + α + λ + β e − 1
q
β = (α + λ)2 + 2σ 2.
• The Longstaff model

q q
dr(t) = α γ − r(t) dt + σ r(t)dB(t).
The model results in a complex function for the ZC bond price of the form
√
F (τ )+G(τ )r+H(τ ) r
P (τ, r) = e .
Remarks on Longstaff model
• Longstaff argues that the non-linearity of the yield curve implied by the model does
bring extra explanatory power to the model.
• However, the pricing of even intermediate term discount bond can be more
complex than can be accommodated within the context of one factor model.

• Black, Derman and Toy model
This model also avoids the problem of negative interest rates and allows for time
dependent parameters. The model is of mean reverting type in the natural algorithm
of interest rate:

d ln r(t) = γ(t) − φ(t) ln r(t) dt + σ(t)dB(t).
The model has desirable features of positive interest rates, ability to model the
volatility curve observable in the market, and thus has the ability to fit the observable
yield curve. However, the model’s liability is the lack of tractable analytical solutions.
• Black and Karasinski model
In the natural algorithm of interest rate, this model is a time-varying version of the
Vasicek model in which the speed of mean reversion, the expected long term interest
and the volatility are all time varying. The model is of the form:

d ln r(t) = α(t) ln γ(t) − ln r(t) dt + σ(t)dB(t).
As the model is quite complicated to get a closed form expression for the price of ZC
bond, Black and Karasinski used lattice approach.

Two-factor interest rate models
• Brennan and Schwartz model
Brennan and Schwartz (1979) introduces a two-factor model where both a long-term
rate and a short-term rate follow a diffusion process. The long-term rate is defined as
the yield on a consol (perpetual) bond. The log of the short-rate evolves as follows

d ln r(t) = α ln γ(t) − ln p − ln r(t) dt + σ1dB1(t),
where p the target value of ln r relative to the level of ln γ , and γ is the consol rate,
2
dγ(t) = γ(t) γ(t) − r(t) + σ2 + λ2σ2 dt + σ2γ(t)dB2(t).
• Two-factor Vasicek model
Other extensions of mean-reverting type short-rate model have been proposed by many
authors, see among others, Chen and Scott (1992), Hull and White (1993), Longstaff
and Schwartz (1992). Hull and White’s model assumes the nominal short rate r as the
sum of two factors x1 and x2 each of which is modeled after the Vasicek model:

dxi (t) = αi γi − xi (t) dt + σidBi(t),

i.e., r = αx1 + βx2 , where B1 and B2 are two independent Brownian Motions.
Due to the independence structure of the factors, the price of ZC bond is of the form:
V (t, x1 , x2 ; T ) = P1 (t, x1 ; T )P2 (t, x2 ; T ),
where Pi (t, xi ; T ) has the same functional form with that of Vasicek one-factor
model.
Three-factor Term Structure model
Chen (1994) extends the CIR model where the speed of mean reversion α, long-run
interest rate level γ and volatility σ are all stochastic,
q q
dr(t) = α(γ(t) − r(t))dt + σ(t) r(t)dB1(t)
q
dγ(t) = γ − γ(t))dt + ψ γ(t)dB2(t)
ν(b
q
dσ(t) = σ − σ(t))dt + η σ(t)dB3(t).
µ(b

Calibration of Ho and Lee Model to Data

As there is one-to-one correspondence between forward rates and bond prices, i.e.,
∂
f (t, T ) = − log P (t, T ), (89)
∂T
we may bridge the gap between the theoretical forward rate curve (f (0, T ); T > 0)
and to the observed forward rate curve (f ⋆ (0, T ); T > 0), where f ⋆ is defined
similarly as in (89), i.e., f ⋆(t, T ) = − ∂T
∂
log P ⋆ (t, T ). Following (87) and (89),
Z
⋆
T
σ2 2
f (0, T ) = r0 + θ(s)ds − T − λσT.
0 2
The function θ(t) is obtained by solving the above equation to get
∂ ⋆
θ(t) = f (0, t) + σ 2t + λσ.
∂T
By inserting θ(t) in equations (80)-(81), the bond prices is given by
P ⋆(0, T ) −(T −t)r(t)+(T −t)f ⋆(0,t)− σ 2 t(T −t)2

P (t, T ) = ⋆ e 2 (90)
P (0, t)

Forward Rate Models
Heat-Jarrow-Morton Framework
We have previously discussed interest rate models in which the short-rate r is the only
state variable. The main advantages of such models:
• allowing us to use partial differential equations (PDE) to get the price of ZC bond.
• allowing us to get analytical formulas for the bond prices, etc.
The main drawbacks of the short rate models:
• from the view point of economics, it seems unreasonable to assume that the entire
money market is governed by only one state variable.
• it is hard to get a realistic volatility structure for the forward rates without
introducing a very complicated short rate model.
• the inversion of yield curve (through the concept of parallel shift of the yield) as
discussed before becomes increasingly more difficult to get a realistic one.

In the section where we discuss the calibration of Ho and Lee model to the terms
structure data, we find it more convenient to work with forward rate.
[Assumption] Assume that for every fixed T > 0, the forward rate f (t, T ) follows
Z t Z t
⋆
f (t, T ) = f (0, T ) + α(s, T )ds + σ(s, T )dB(s) (91)
0 0
The Proposition 5 below provides condition on the drift α of the forward rate model
(91) so that the price of ZC bond under the forward rate model
R
− tT f (t,u)du
P (t, T ) = e , (92)
coincides with the one under the risk-neutral pricing measure Q

RT
Q − t r(u)du
P (t, T ) = E e Ft .
Proposition 5. HJM drift conditionUnder risk-neutral measure Q, the drift α and

the volatility σ of the HJM model (91) must satisfy the following relation:
Z T
α(t, T ) = σ(t, T ) σ(t, s)ds (93)
t

In order to apply the HJM model, we need to
• specify the structure of the volatility σ(t, T ).

• the drift parameter of the forward rate is specified by (93).
• collect the forward rate structure (f ⋆(0, T ); T ≥ 0) from the market.
• take the forward rate model as in (93).
• compute the ZC bond price using the formula (92).
Exercise Consider HJM forward rate model with constant volatility, i.e.,
σ(t, T ) = σ , with σ > 0. On account of the fact that r(t) = f (t, t), show that
the corresponding short rate dynamics is given by the Ho and Lee model
dr(t) = θ(t)dt + σdB(t),
where the drift θ(t) is specified by
∂ 2
θ(t) = f (0, t) + σ t.
∂T
As discussed earlier, this model perfectly fits the initial term structure. See eqn (90).

Parameters Estimation of Term Structure Models

We are interested in estimating the parameters of the Vasicek model
dr(t) = α(γ − r(t))dt + σdB(t).
Due to the expression (85), we know that

σ2
−αt −2αt
r(t) ∼ N γ + e (r0 − γ), 1−e . (94)
2α
There are many approaches in doing so. Below are some of them.
• Simple regression approach ∆r = a + br + ǫ.
The parameter estimates of the Vasicek model is given by
a
b
α = −bb and γ = − .
bb
Drawbacks of regression model The regression equation has literally zero

explanatory power and neither a nor b are statistically significant.

• Volatility curve approach
This approach explores the relationship between the yield and short rate:
y(τ ) = f (τ ) + g(τ )r,
(1−e−ατ )
where g(τ ) = ατ , and r is normally distributed, see equation (94).
The model is calibrated using yield volatilities data of various maturities,

2
Var(y(τ )) = g (τ )Var(r).
Find the best fitting values of α and σ that best fit the yield volatilities.
• Fitting parameters to volatility-sensitive instruments
Estimating the interest rate parameters from interest-rate derivative instruments.
Remark It is similar to the estimation of stock price volatility from the observable
prices on options on common stock by minimizing the SSE in the pricing formula.
• Maximum likelihood approach

Derivatives and Option Pricing

Theory

Forward and Futures Contract
Forward Contract
Forward contract is a relatively simple derivative. It is an agreement to buy or sell an

asset at a certain future time for a certain price, in contrast to spot contract, which is
an agreement to buy or sell an asset today.
There are two prices or values associated with a forward contract. The first is the
forward price F . This is the delivery price of a unit of the underlying asset to be
delivered at a specific future date. It is the delivery price that would be specified in a
forward contract written today.
The second price or value of a forward contract is its current value, denoted by f .
The forward price F is determined such that f = 0 initially, so that no money need
be exchanged when completing the contract agreement. After the initial time, the
value of f may vary, depending on variations of the spot price of the underlying asset,
the prevailing interest rates, and other factors.

Forward Contract: Continued Let us determine the theoretical forward price F

associated with forward contract written at time t = 0 to deliver an asset at time T .
Our analysis depends on the standard assumption that
• there are no transaction costs, and that assets can be divided arbitrarily.
• Also, we assume initially that it is possible to store the underlying asset without
cost and it is possible to sell short.
• Later we will allow for storage cost, but still require that it be possible to store the
underlying asset for the duration of the contract20.
Illustration Suppose we buy one unit of the commodity at price S on the spot market
and simultaneously enter a forward contract to deliver at time T one unit at price F .
We store the commodity until T and deliver it to meet our obligation and obtain F .
This must be consistent with the interest rate between t = 0 and t = T . Hence,
S = B(0, T )F
In other words, because storage is costless, buying the commodity at price S is exactly
the same as lending an amount S of cash for which we will receive an amount F at T .
20 This is a good assumption for many assets, such as gold or sugar, or T −bills, but perhaps not good for perishable
commodities such as oranges.

Forward Price Formula
Theorem 2. Suppose that an asset can be stored at zero cost. Suppose that the
current spot price (at t = 0) of the asset is S . The theoretical forward price F (for
delivery at T ) is
F = B −1(0, T )S,
where B(0, T ) is the discount factor between t = 0 and T .
Proof. Suppose contrary that F > B −1(0, T )S . Then construct a hedging portfolio
as follows. At the present time borrow S amount of cash, buy one unit of the
underlying asset on the spot market at price S , and take a one-unit short position in
the forward market. The total cost of this portfolio is zero. At time T we deliver the
asset, receiving a cash amount F , and we repay our loan in the amount B −1(0, T )S .
As a result, we obtain a positive profit of F − B −1(0, T )S for zero net investment.
This is an arbitrage, which we assume is impossible.
 
At t = 0 Initial Cost Final Receipt
 
 Borrow $S -S -B −1 (0, T )S 
 
 Buy one unit and store S 0 
 
 Short one forward 0 F 
Total 0 F − B −1 (0, T )S

Forward Price Formula: Continued
If F < B −1(0, T )S . Then construct a reverse portfolio. Borrow the asset from
someone who plans to store it during this period, and then sell the borrowed asset at
the spot market, and replacing the borrowed asset at time T .
 
At t = 0 Initial Cost Final Receipt
 
 Lending $S S B −1(0, T )S 
 
 Short one unit -S 0 
 
 Go long one forward 0 -F 
Total 0 B −1(0, T )S − F
Our profit is B −1(0, T )S − F (which we might share with the asset lender for
making the short possible).
Since either inequality leads to an arbitrage opportunity, equality must hold. 2

The Value of Forward Contract
Suppose a forward contract was written in the past with a delivery price of F0. At the
present time t the forward price for the same delivery date is Ft. The following
determines the value ft of the initial contract.
Theorem 3. Suppose that a forward contract for delivery at time T in the future
has a delivery price F0 and a current forward price Ft. The value of the contract is
ft = (Ft − F0)B(t, T ),
where B(t, T ) is the risk-free discount factor over the period from t to T .
Proof. Construct the following portfolio at time t. One unit long of a forward
contract with delivery price Ft maturing at time T , and one unit short of the contract
with delivery price F0. The initial cash flow of this portfolio is ft . The final cash flow
at time T is F0 − Ft. The present value of this portfolio is ft + (F0 − Ft)B(t, T ),
and this must be zero, otherwise arbitrage opportunity exists. 2

Futures Contract
Like the forward contract, a futures contract is an agreement between two parties to
buy or sell an asset at a certain time in the future for a certain price.
Unlike forward contracts, futures contract are normally traded on an exchange. To

make trading possible, the exchange specifies certain standardized features of the
contract. The buyer and seller do not necessarily know each other. The exchange
provides a mechanism that gives the two parties a guarantee that the contract will be
honored.
Because forward trading is so useful, it became desirable long ago to standardized the
contracts and trade them on an organized exchange.
However, standardization of forward prices is impossible. To see this. Suppose that

contracts were issued today at a delivery price of F0. The exchange would keep track
of all such contracts. Then tomorrow the forward price might change and contracts
initiated that day would have a different delivery price F1. In fact, the appropriate
delivery price might change continuously throughout the day. The thousands of
outstanding forward contracts could each have a different delivery price, even though
all other terms were identical. This would be a bookkeeping nightmare.

Futures Contract: Continued
This problem is solved by the invention of futures market. Multiple delivery prices are
eliminated by revising contracts as the price environment changes.
Consider again the situation where contracts are initially written at F0 and then the
next day the price for new contracts is F1. At the second day, the clearinghouse
associated with the exchange revises all the earlier contracts to the new delivery price
F1. To do this, the contract holders either pay or receive the differences. Suppose
that F1 > F0 and hold a one unit long position with price F0. My contract price is
then changed to F1 and receive F1 − F0 from the clearing house because we will later
have to pay F1 rather than F0 when we receive delivery of the commodity.
Theorem 4. [Futures-forward equivalence] Theoretical futures and forward prices

of corresponding contracts are identical.

Option Pricing: Basic Theory

Option is a contract which gives the holder of the contract a right, not obligation, to
buy (or sell) an asset under specified terms: a specified price and period of time.
There are two type of Options: American and European. European option allows
exercise only on the expiration date, whilst the American option allows exercise at any
time before the experation date.
There are six factors affecting the price of a stock option:
• The current stock price.

• The strike price.
• The time to expiration.
• The volatility of the stock price.
• The risk-free interest rate.
• The dividends expected during the life of the option.
We will denote by c and p (subsequently by C and P ) the value of European (or

American) call and put options, S0 current stock price, ST stock price at time T , T
the expiration time, r risk-free interest rate, and by K the strike price.

Lower and Upper Bounds for Option Prices
It can be argued that the call and put options have the upper bounds:
c ≤ S0 and C ≤ S0
p≤K and P ≤ K.
In particular, the European options satisfies the inequality:
c ≥ max(S0 − Ke−rT , 0)
p ≥ max(Ke−rT − S0 , 0)
To prove this inequality for call option, consider the following two portfolios:
−rT
Portfolio A: one European call option + an amount of cash equal to Ke .
Portfolio B: one share.
Example Suppose that S0 = $20, K = $18, r = 10% per annum, and T = 1

year.
c = S0 − Ke−rT = 20 − 18e−1 = 3.71.

European Put-Call Parity Relation
For the European call option, there is an important relationship between p and c.
Consider the following two portfolios:
−rT
Portfolio A: one European call option + an amount of cash equal to Ke .
Portfolio B: one European put option + one share.
At the expiration date, both portfolios are worth at max(ST , K). This means that
−rT
c + Ke = p + S0.
If the inequality does not hold, then there would be an arbitrage opportunity.
Relationship Between American Put and Call Options
It can be shown using no arbitrage opportunity strategy that

−rT
S0 − K ≤ C − P ≤ S0 − Ke .

Binomial Option Pricing
The basic theory of binomial options pricing goes as follows. Suppose that the initial
price of a stock is S . At the end of the period the price will either be uS with
probability p or dS with probability 1 − p. Assume that u > d > 0. Also at every
period it is possible to borrow or lend at a common risk-free interest rate r . We define
R := 1 + r . To avoid the arbitrage opportunity, we assume that u > R > d.
Figure 7: Binomial scenario.

Binomial Option Pricing: Continued
Suppose that the outcome of the European call option :
cu = max(uS − K, 0); cd = max(dS − K, 0),
can be replicated by a portfolio consisting of stock and bond each of which is worth x
and y dollars according to
ux + Ry = cu and dx + Ry = cd.
The solution to these equations are given by
cu − cd ucd − dcu
x= and y = . (95)
u−d R(u − d)
Using the no-arbitrage argument, the value of the European call option c is therefore
equal to the value of the portfolio x + y , i.e.,
1 R−d
c=x+y = qcu + (1 − q)cd , where q = . (96)
R u−d

Binomial Option Pricing: Continued
Lemma 1. The value of a one-period European call option on a stock governed by a

binomial lattice is given by
1 R−d
c= qcu + (1 − q)cd , where q = . (97)
R u−d
In short-hand notation, we can write

1 Q
c(T − 1) = E c(T ) .
R
Remarks
• The equation (97) states that the call option value c is found by taking the
expected value of the option under the risk-neutral probability q .
• This procedure of valuation works for all securities, including the underlying stock
1
S= quS + (1 − q)dS (98)
R
from which one can recover the risk-neutral probability q .

Multiperiod Call Option Pricing: Continued
Figure 8: Multiperiod call option pricing.
where the value of the option is known at the final nodes of the lattice. In particular,
2 2
Cuu = max(u S − K, 0); Cud = max(udS − K, 0); Cdd = max(d S − K, 0).

Multiperiod Call Option Pricing: Continued
As before, the risk-neutral probability q is defined as
R−d
q= .
u−d
The values of cu and cd are found using the single-period calculation given earlier:
1
cu = qcuu + (1 − q)cud
R
1
cd = qcud + (1 − q)cdd
R
By another application of the risk-neutral discounting formula, we find
1
c= qcu + (1 − q)cd (99)
R

Multiperiod Put Option Pricing: Continued
Figure 9: Multiperiod put option pricing.
where the value of the option is known at the final nodes of the lattice. In particular,
2 2
puu = max(K − u S, 0); pud = max(K − udS, 0); pdd = max(K − d S, 0).

Stock price dynamics
To specify the European call option valuation model, we need to specify the values of
u, d and the objective probability p.
Define ν as the expected yearly growth rate, i.e.

ν = E ln(ST /S0 ) ,
where S0 is the initial stock price and ST is the price at the end of year 1. Likewise,
we define σ as the yearly standard deviation, i.e.

σ 2 = Var ln(ST /S0 ) .
If the period time length ∆t small enough compared to 1, the parameters of the
binomial lattice can be selected as
1 1 ν √
p = + ∆t (100)
2 2 σ
√
σ ∆t
u = e (101)
√
−σ ∆t
d = e . (102)

Stock price dynamics
Figure 10: Stock dynamics.

Storage Costs and Dividends
Storage costs and dividends may complicate an evaluation procedure. But, there is an
important special case, of proportional costs or dividends, that can be handled easily.
Suppose that a commodity price S is governed by a binomial process having an up

factor u and a down factor d. There is a storage cost of cS per period, payable at the
end of each period. The total risk-free return per period is R.
At the end of the period, the commodity is received minus the storage cost; hence the
amount received is either (u − c)S or (d − c)S . The factors u − c and d − c are
the legitimate factors that define the result of holding the commodity.
It follows that the risk-neutral probabilities are given by
R−d+c u−c−R
q= , and 1 − q = .
u−d u−d

The Black-Scholes Formula
To begin with, assume that the stock price dynamics is of the form
dS = µSdt + σdW (t), (103)
where W is the standard Brownian motion. Suppose also that there is a risk-free
zero-coupon bond carrying an interest rate of r over the period [0, T ] with
dB = rBdt. (104)
Let C(S, t) denote the price of the option at time t when the stock price is S . This
function solves the famous Black-Scholes formula.
Theorem 5. Suppose that the price of an asset is governed by (103) and the
risk-free interest rate is r . A derivative of this security has a price C(S, t) satisfying
the PDE:
∂C ∂C 1 ∂ 2C 2 2
+ rS + 2
σ S − rC = 0. (105)
∂t ∂s 2 ∂s
Solution to this equations is given by the renowned Black-Scholes-Merton model:

C(S, t) = SN d1) − Ke−r(T −t)N (d2)

ln S/K) + (r + σ 2/2)(T − t)
d1 = √
σ T −t
p
d2 = d1 − σ T − t
Proof of the Black-Scholes Formula
The proof is established by constructing replicating self-financing portfolio consisting

bond and stock, i.e.,
Vt = xt St + ytBt .
The portfolio strategy x and y are selected such that Vt replicates the value of the
call option.
The instantaneous gain in the value of the portfolio due to changes in security prices
(the investment gain) is therefore
dVt = xt dSt + ytdBt.

Multiperiod Put Option Pricing: Home Works
The method for calculating the values of European put options is analogous to that
for call options. The main difference is the terminal values for the option are different.
But once these are specified, the recursive procedure works in a similar way.
Exercise[One-year call option] Consider a European call option on stock maturing one
year from now. Assume that a volatility of the algorithm of the stock is σ = 0.2. The
current price of the stock is S = $62 and the strike price is K = $60. The risk-free
interest rate is at r = 10%, compounded monthly. Compute the theoretical price of
the option using the binomial option pricing approach. compare the result with
Black-Scholes formula
Exercise[One-year put option] Consider a put option on stock maturing one year from
now. Assume that a volatility of the algorithm of the stock is σ = 0.2. The current
price of the stock is S = $62 and the strike price is K = $60. The risk-free interest
rate is at r = 10%, compounded monthly. Compute the theoretical price of the
option using the binomial option pricing approach. compare the result with
Black-Scholes formula

Main References
References
[1] Bjork, T. Arbitrage Theory in Continuous Time, Oxford University Press, 2004.
[2] Campbell, J, Y., Lo, A. W and MacKinlay, A. C. The Econometrics of Financial
Markets, Princeton University Press, 1997.
[3] Hull, J. Options, Futures, And Other Derivatives, Sixth Edition, Pearson
Prentice Hall, 2006.
[4] Luenberger, D. Investment Science, Oxford University Press, 1998.
[5] Van Deventer, D. R., Imai, K., and Mesler, M. Advanced Financial Risk
Management: Tools and Techniques for Integrated Credit Risk and Interest
Rate Risk Management, Willey, 2005.
[6] Martin, J. D., Cox, Jr. S. C., and MacMinn, R. D. The Theory of Finance:
Evidence and Application, The Dryden Press, 1988.

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An Introduction to Capital Markets

September 21, 2010

An Introduction to Capital Markets and Investment, SBM-ITB, August 2010 1

Definitions and Conventions

An Introduction to Capital Markets and Investment, SBM-ITB, August 2010 2

Definitions and Conventions: Continued

If single-period returns Rt’s are relatively small in magnitude, first-order Taylor

Continuous Compounding The continuously compounded return or log return rt of

An Introduction to Capital Markets and Investment, SBM-ITB, August 2010 3

Continuous Compounding: Continued

The continuously compounded returns become advantageous when considering

Drawbacks of Continuously Compounded Returns

Consider a portfolio of N assets whose value is given by

An Introduction to Capital Markets and Investment, SBM-ITB, August 2010 4

Distributional Properties of Asset Returns

• Normal Distributional Properties

• Log-Normal Distributional Properties

An Introduction to Capital Markets and Investment, SBM-ITB, August 2010 5

• Log-Normal Distributional Properties: Continued

• Non-Normal Distributional Properties of Log-Returns

An Introduction to Capital Markets and Investment, SBM-ITB, August 2010 6

Distributional Properties of Asset Returns: Continued

data ghyp.data Theoretical Quantiles

An Introduction to Capital Markets and Investment, SBM-ITB, August 2010 7

Efficient Capital Markets

An Introduction to Capital Markets and Investment, SBM-ITB, August 2010 8

Efficient Market Hypothesis

The origins of the Efficient Market Hypothesis2 can be traced back to

• the pioneering theoretical contribution of Bachelier (1900) and the empirical

An Introduction to Capital Markets and Investment, SBM-ITB, August 2010 9

Efficient Market Hypothesis: Continued

Definition 1. A capital market is said to be efficient if it fully and correctly reflects

Remarks on Malkiel definition of EMH

• The first sentence of Malkiel definition repeats Fama’s definition.

An Introduction to Capital Markets and Investment, SBM-ITB, August 2010 10

Efficient Market Hypothesis: Continued

• Alternatively, one can ask whether hypothetical trading based on an explicitly

An Introduction to Capital Markets and Investment, SBM-ITB, August 2010 11

Efficient Market Hypothesis: Continued

An Introduction to Capital Markets and Investment, SBM-ITB, August 2010 12

The Law of Iterated Expectations

As discounted present-value model of security prices is found to be entirely consistent

Let us now consider expectation of a random variable X conditional on these

An Introduction to Capital Markets and Investment, SBM-ITB, August 2010 13

The Law of Iterated Expectations: Continued

An Introduction to Capital Markets and Investment, SBM-ITB, August 2010 14

The Law of Iterated Expectations: Continued

Alternatively, a game is fair if the expected incremental investment wealth at any

An Introduction to Capital Markets and Investment, SBM-ITB, August 2010 15

Asset Dynamics: The Random Walk Hypothesis

1. The Random Walk I: IID Increments

The simplest version of the RW hypothesis is the IID increments case

An Introduction to Capital Markets and Investment, SBM-ITB, August 2010 16

Exercise Conditional on P0 , show that

An Introduction to Capital Markets and Investment, SBM-ITB, August 2010 17

2. The Random Walk II: Independent Increments

Pt = µ + Pt−1 + σt−1ǫt, where ǫt ∼ IID(0, 1), (6)

where σt accounts for the time-variation in volatility of the asset price Pt .

An Introduction to Capital Markets and Investment, SBM-ITB, August 2010 18

Capital Asset Pricing Model (CAPM)

An Introduction to Capital Markets and Investment, SBM-ITB, August 2010 19

The Economic Models of Asset Returns

Assumption Let R be an (N × 1) vector of asset returns for calendar time period