# Interest rates stochastic models

Ioane Muni Toke
Ecole Centrale Paris
Option Math´ematiques Appliqu´ees
Majeure Math´ematiques Financi`eres
December 2010 - January 2011
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 1 / 61
Course outline
Lecture 1 Basic concepts and short rate models
Lecture 2 From short rate models to the HJM framework
Lecture 3 Libor Market Models
Lecture 4 Practical aspects of market models - I
(E.Durand, Soci´et´e G´en´erale)
Lecture 5 Practical aspects of market models - II
(E.Durand, Soci´et´e G´en´erale)
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 2 / 61
Useful bibliography
This short course uses material from :
Brigo D. and Mercurio F. (2006). Interest rates models - Theory and
Practice, 2nd edition, Springer.
Martellini L. and Priaulet P. (2000). Produits de taux d’int´erˆet,
Economica.
Shreve S. (2004). Stochastic Calculus for Finance II:
Continuous-Time Models, Springer.
Original research papers (references below).
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 3 / 61
Part I
Basic concepts
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 4 / 61
Spot interest rates
r (t) : Instantaneous (interbank) rate, or short rate.
P(t, T) : Price at time t of a T-maturity zero-coupon bond
R(t, T) : Continuously-compounded spot interest rate
R(t, T) = −
ln P(t, T)
T − t
i.e. P(t, T) = e
−R(t,T)(T−t)
(1)
L(t, T) : Simply-compounded spot interest rate
L(t, T) =
1 −P(t, T)
P(t, T)(T − t)
i.e. P(t, T) =
1
1 + L(t, T)(T − t)
(2)
Y(t, T) : Annually-compounded spot interest rate
Y(t, T) =
1
P(t, T)
1/(T−t)
− 1 i.e. P(t, T) =
1
(1 + Y(t, T))
(T−t)
(3)
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 5 / 61
Term structure of interest rates
Reproduced from “Danish Government Borrowing and Debt 1998”, Danmarks National Bank, 1999.
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 6 / 61
Forward interest rates
Forward-rate agreement : exchange of a ﬁxed-rate payment and a
ﬂoating-rate payment
L(t, T, S) : Simply-compounded forward interest rate
L(t, T, S) =
1
S −T
_
P(t, T)
P(t, S)
− 1
_
i.e. 1 + (S −T)L(t, T, S) =
P(t, T)
P(t, S)
(4)
f (t, T) : Instantaneous forward interest rate
f (t, T) = −
∂ ln P(t, T)
∂T
i.e. P(t, T) = exp
_

_
T
t
f (t, u)du
_
(5)
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 7 / 61
Swap rates
Exchange of ﬁxed-rate cash ﬂows and ﬂoating-rate cash ﬂows
Exchanges at dates T
α+1
, . . . , T
β
, with τ
i
= t
i
− T
i −1
Value at time t of a receiver swap :
Π
RS
(t, α, β, N, K) = −N(P(t, T
α
) − P(t, T
β
) + N
β

i =α+1
τ
i
KP(t, T
i
)
(6)
Swap rate
S
α,β
(t) =
P(t, T
α
) − P(t, T
β
)

β
i =α+1
τ
i
P(t, T
i
)
(7)
S
α,β
(t) =
1 −

β
j =α+1
1
1+τ
j
L(t,T
j −1
,T
j
)

β
i =α+1
τ
i

i
j =α+1
1
1+τ
j
L(t,T
j −1
,T
j
)
(8)
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 8 / 61
Caps, ﬂoors and swaptions
Cap : Payer swap in which only positive cash ﬂows are exchanged
Floor : Receiver swap in which only positive cash ﬂows are exchanged
Caplet (ﬂoorlet) : One-date cap (ﬂoor), i.e. contract with payoﬀ at
time T
i

i
[L(T
i −1
, T
i
) − K]
+
. (9)
Swaption : A European payer swaption is an option giving the right
to enter a payer swap (α, β) at maturity T, i.e. contract with payoﬀ
at time T if T = T
α
N
_
β

i =α+1
τ
i
P(T
α
, T
i
) [L(T
α
, T
i −1
, T
i
) − K]
_
+
. (10)
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 9 / 61
Part II
Short-rate models
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 10 / 61
1
The Vasicek model
2
The CIR model
3
The Hull-White (extended Vasicek) model
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 11 / 61
The Vasicek model
1
The Vasicek model
2
The CIR model
3
The Hull-White (extended Vasicek) model
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 12 / 61
The Vasicek model
Model deﬁnition
Original paper
Vasicek, O. (1977). “An equilibrium characterization of the term
structure”, Journal of Financial Economics, 5 (2), 177–188.
Dynamics of the short rate
Short rate r (t) follows an Ornstein-Uhlenbeck process
dr
t
= κ[θ − r
t
]dt + σdW
t
(11)
with κ, θ, σ positive constants.
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 13 / 61
The Vasicek model
Dynamics of the short rate
Proposition
In the Vasicek model, the SDE deﬁning the short rate dynamics can be
integrated to obtain
r (t) = r (s)e
−κ(t−s)
+ θ(1 − e
−κ(t−s)
) + σ
_
t
s
e
−κ(t−u)
dW
u
(12)
Short rate r (t) is normally distributed conditionally on F
s
.
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 14 / 61
The Vasicek model
Price of zero-coupon bonds
Proposition
In the Vasicek model, the price of a zero-coupon bond is given by
P(t, T) = A(t, T)e
−B(t,T)r(t)
(13)
with
_
¸
¸
_
¸
¸
_
A(t, T) = exp
_
(θ −
σ
2

2
)(B(t, T) − (T − t)) −
σ
2

B(t, T)
2
_
B(t, T) =
1 − e
−κ(T−t)
κ
(14)
Explicit pricing formula.
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 15 / 61
The Vasicek model
Continuously-compounded spot rate
Proposition
In the Vasicek model, the continuously-compounded spot rate is written
R(t, T) = R

+(r
t
−R

)
1 −e
−κ(T−t)
κ(T − t)
+
σ
2

3
(T − t)
(1−e
−κ(T−t)
)
2
(15)
with
R

= θ −
σ
2

2
(16)
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 16 / 61
The CIR model
1
The Vasicek model
2
The CIR model
3
The Hull-White (extended Vasicek) model
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 17 / 61
The CIR model
Model deﬁnition
Original paper
Cox J.C., Ingersoll J.E. and Ross S.A. (1985). ”A Theory of the Term
Structure of Interest Rates”. Econometrica 53, 385–407.
Dynamics of the short rate
Short rate is given by the following SDE
dr
t
= κ[θ − r
t
]dt + σ

r
t
dW
t
(17)
with κ, θ, σ positive constants satisfying σ
2
< 2κθ.
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 18 / 61
The CIR model
Dynamics of the short rate
Proposition
In the CIR model, the short rate r (t) follows a noncentral χ
2
distribution
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 19 / 61
The CIR model
Pricing of zero-coupon bonds
Proposition
In the CIR model, the price of a zero-coupon bond is
P(t, T) = A(t, T)e
−B(t,T)r(t)
(18)
with
_
¸
¸
¸
¸
¸
¸
_
¸
¸
¸
¸
¸
¸
_
A(t, T) =
_
2γe
κ+γ
2
(T−t)
2γ + (κ + γ)(e
γ(T−t)
− 1)
_2κθ
σ
2
B(t, T) =
2(e
γ(T−t)
− 1)
2γ + (κ + γ)(e
γ(T−t)
− 1)
γ =
_
κ
2
+ 2σ
2
(19)
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 20 / 61
The Hull-White (extended Vasicek) model
1
The Vasicek model
2
The CIR model
3
The Hull-White (extended Vasicek) model
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 21 / 61
The Hull-White (extended Vasicek) model
Model deﬁnition
Original paper
J Hull and A White (1990). ”Pricing interest-rate-derivative securities”.
The Review of Financial Studies 3, 573–592.
Dynamics of the short rate
Short rate is given by the following SDE
dr
t
= [b(t) − ar
t
]dt + σdW
t
(20)
with a and σ positive constants.
Non-time-homogeneous extension of the Vasicek model.
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 22 / 61
The Hull-White (extended Vasicek) model
Model deﬁnition
Proposition
This model can exactly ﬁt the term-structure observed on the market by
setting
b(t) =
∂f
M
∂T
(0, t) + af
M
(0, t) +
σ
2
2a
(1 −e
−2at
) (21)
Dynamics of the short rate
The short rate SDE can then be integrated to obtain :
r (t) = r (s)e
−a(t−s)
+ α(t) − α(s)e
−a(t−s)
+ σ
_
t
s
e
−a(t−u)
dW
u
(22)
with α(t) = f
M
(0, t) +
σ
2
2a
2
(1 −e
−at
)
2
.
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 23 / 61
The Hull-White (extended Vasicek) model
Price of zero-coupon bonds
Proposition
In the Hull-White model, the price of a zero-coupon bond is given by
P(t, T) = A(t, T)e
−B(t,T)r(t)
(23)
with
_
¸
_
¸
_
A(t, T) =
P
M
(0, T)
P
M
(0, t)
exp
_
B(t, T)f
M
(0, t) −
σ
2
4a
(1 − e
−2at
)B(t, T)
2
_
B(t, T) =
1
a
(1 − e
−a(T−t)
)
(24)
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 24 / 61
The Hull-White (extended Vasicek) model
Price of options on a zero-coupon bond
Proposition
In the Hull-White model, the price of a european call option, with strike K
and maturity T, on a zero-coupon bond of maturity S > T, can be written
C
HW
ZC
= P(t, S)N(q
1
) − KP(t, T)N(q
2
) (25)
with
_
¸
¸
_
¸
¸
_
σ
T
r
= σ
_
1−e
−2a(T−t)
2a
B(T, S)
q
1
=
1
σ
T
r
ln
P(t,S)
KP(t,T)
+
σ
T
r
2
q
2
= q
1
− σ
T
r
(26)
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 25 / 61
Part III
From short rate models to HJM framework
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 26 / 61
4
Multifactor models
5
The HJM framework
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 27 / 61
Multifactor models
4
Multifactor models
5
The HJM framework
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 28 / 61
Multifactor models
Motivations
Empirical studies : correlations of interests rates by maturity
Reproduced from Martellini, Priaulet, 2000.
Empirical studies : PCA on correlation matrix
Reproduced from Jamshidian, Zhu, (1997), Finance and Stochastics 1(1), 43–67.
Correlation in one-factor aﬃne term structure models
Arbitrage in short/long rates models (Dybvig, Ingersoll, Ross, (1996))
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 29 / 61
Multifactor models
A Gaussian two-factor model (I)
Model deﬁnition
The short rate r (t) is written
r (t) = x(t) + y(t) + φ(t), r (0) = r
0
, (27)
where the two factors x and y are solutions of the following SDEs :
_
dx(t) = −ax(t)dt + σdW
1
(t), x(0) = 0,
dy(t) = −by(t)dt + ηdW
2
(t), y(0) = 0,
(28)
with dW
1
, W
2

t
= ρ and φ is a deterministic function such that
φ(0) = r
0
.
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 30 / 61
Multifactor models
A Gaussian two-factor model (II)
Price of a zero-coupon bond
In the Gaussian two-factor model, the price P(t, T) at time t of the
T-maturity zero-coupon bond can be written
P(t, T) = exp{−
_
T
0
φ(u)du −
1−e
−a(T−t)
a
x(t) −
1−e
−b(T−t)
b
y(t) +
1
2
V(t, T)}
(29)
Fitting the observed term structure
The Gaussian two-factor model ﬁts the observed term structure P
M
(0, T)
if and only if φ is written
φ(T) = f
M
(0, T)+
σ
2
2a
2
(1−e
aT
)
2
+
η
2
2b
2
(1−e
bT
)
2

ση
ab
(1−e
aT
)(1−e
bT
)
(30)
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 31 / 61
Multifactor models
A Gaussian two-factor model (III)
Pricing of zero-coupon bond
In the Gaussian two-factor model, the price P(t, T) at time t of the
T-maturity zero-coupon bond can be written
P(t, T) = A(t, T) exp{−B
a
(t, T)x(t) − B
b
(t, T)y(t)} (31)
where
_
¸
¸
_
¸
¸
_
A(t, T) =
P
M
(0, T)
P
M
(0, t)
exp{
1
2
(V(t, T) − V(0, T) + V(0, t))},
B
i
(t, T) =
1 − e
−i (T−t)
i
.
(32)
First step allowing the modeling of correlations.
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 32 / 61
The HJM framework
4
Multifactor models
5
The HJM framework
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 33 / 61
The HJM framework
Framework deﬁnition
Original paper
Heath D., Jarrow R. and Morton A.(1992). ”Bond Pricing and the Term
Structure of Interest Rates: A New Methodology”. Econometrica 60,
77–105.
Forward dynamics
The instantaneous forward rates dynamics is given by the following SDE:
_
df (t, T) = α(t, T)dt + σ(t, T)dW
t
,
f (0, T) = f
M
(0, T).
(33)
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 34 / 61
The HJM framework
No arbitrage condition (I)
Dynamics of the zero-coupon bond prices
In a HJM framework, the price of the T-maturity zero-coupon bond is
solution of the following SDE:
dP(t, T) = P(t, T)
_
r
t
− α

(t, T) +
1
2
σ

(t, T)
2
_
dt−σ

(t, T)P(t, T)dW
t
,
(34)
where
_
¸
¸
_
¸
¸
_
α

(t, T) =
_
T
t
α(t, u)du,
σ

(t, T) =
_
T
t
σ(t, u)du.
(35)
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 35 / 61
The HJM framework
No arbitrage condition (II)
Dynamics of the zero-coupon bond prices
In a HJM framework, there is no arbitrage if there exists a process

t
)
0≤t≤
¯
T
satisfying
α(t, T) = σ(t, T) [σ

(t, T) + θ(t)] (36)
In this case, dynamics in the model can be rewritten under a risk-neutral
measure Q :
df (t, T) = σ(t, T)σ

(t, T)dt + σ(t, T)dW
Q
t
dP(t, T) = r
t
P(t, T)dt − σ

(t, T)P(t, T)dW
Q
t
(37)
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 36 / 61
The HJM framework
Markovianity in the HJM framework (I)
Dynamics of the short rate
In a no arbitrage HJM framework, the short rate can be written
r (t) = f (0, t) +
_
t
0
σ(u, t)
_
t
u
σ(u, s)ds du +
_
t
0
σ(u, t)dW
u
(38)
Choice of volatilities to get a markovian model:
Separation of variables : σ(t, T) = ξ(t)φ(T)
Ritchken and Sankarasubramanian (1995) : σ(t, T) = η(t)e

T
t
κ(u)du
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 37 / 61
The HJM framework
Markovianity in the HJM framework (II)
Ritchken and Sankarasubramanian volatility (1995)
In a 1D HJM framework with σ(t, T) T-diﬀerentiable, every derivative
product is completely determined by a two-dimensional Markov process if
and only if σ(t, T) = η(t)e

T
t
κ(u)du
where η is an adapted process and κ
is a deterministic and integrable process.
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 38 / 61
The HJM framework
Proposition
If the SDE dr
t
= b(t, r
t
)dt + γ(t, r
t
)dW
t
deﬁnes a short rate model with
an aﬃne term structure P(t, T) = A(t, T)e
−B(t,T)r(t)
, then this model
belongs to the HJM framework with σ(t, T) =

∂T
B(t, T)γ(t, r
t
).
One can check that the Vasicek, CIR and Hull-White models are
one-dimensional no-arbitrage HJM models.
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 39 / 61
The HJM framework
Choices of volatility
Ho-Lee
σ(t, T) = σ (constant) (39)
Vasicek/Hull-White
σ(t, T) = γ(t)e
−λ(T−t)
(40)
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 40 / 61
The HJM framework
Pricing of caplet
Proposition
In a no-arbitrage HJM framework, the price of a caplet of maturity T,
strike K, paid in T + θ is written :
C(t, T, K, θ) = P(t, T +θ) [(1 + θL(t, T, T + θ)N(d
1
) − (1 + θK)N(d
0
)]
(41)
where
_
¸
¸
¸
¸
_
¸
¸
¸
¸
_
d
0
=
1
Σ(t, T)
ln
1 + θL(t, T, T + θ)
1 + θK

1
2
Σ
2
(t, T)
d
1
= d
0
+ Σ(t, T)
Σ(t, T) =
_
T
t

(u, T + θ) − σ

(u, T))
2
du
(42)
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 41 / 61
Part IV
Libor market models
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 42 / 61
6
Change of numeraire
7
The Black Formula
8
The BGM market model
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 43 / 61
Change of numeraire
6
Change of numeraire
7
The Black Formula
8
The BGM market model
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 44 / 61
Change of numeraire
General change of measure
Theorem
Assume there exists a numeraire (M
t
)
t≥0
and an equivalent measure Q
M
such that the price of any traded asset X “discounted” by the process M
is a Q
M
-martingale, i.e.
X
t
M
t
= E
Q
M
_
X
T
M
T
¸
¸
¸F
t
_
.
Let (N
t
)
t≥0
be a numeraire.
Then there exists an equivalent probability measure Q
N
such that the
price of any traded asset X “discounted” by N is a Q
N
-martingale, i.e.
X
t
N
t
= E
Q
N
_
X
T
N
T
¸
¸
¸F
t
_
.
Q
N
is deﬁned by the Radon-Nikodym derivative
dQ
N
dQ
M
¸
¸
¸
F
T
=
N
T
N
0
M
0
M
T
. (43)
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 45 / 61
Change of numeraire
Changing from risk-neutral measure
Proposition
Let Q be the risk-neutral measure associated with a riskless numeraire
β(t) = e

t
0
r
u
du
. Let X be a traded asset with Q-dynamics
dX
t
= r
t
X
t
dt + σ
X
(t, X
t
)dW
Q
t
(44)
Let N be another traded asset :
dN
t
= r
t
N
t
dt + σ
N
(t, N
t
)dW
Q
t
(45)
Then
X
t
N
t
is a Q
N
-martingale with dynamics :
d
_
X
t
N
t
_
=
X
t
N
t
_
σ
X
(t, X
t
) − σ
N
(t, N
t
)
_
σ
N
(t, N
t
)dW
Q
N
t
(46)
where dW
Q
N
t
= dW
Q
t
− σ
N
(t, N
t
)dt is a Q
N
-brownian motion.
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 46 / 61
The Black Formula
6
Change of numeraire
7
The Black Formula
8
The BGM market model
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 47 / 61
The Black Formula
The Black formula
Proposition
The Black formula for a caplet (maturity T, strike K) on the θ-tenor Libor
L(., . + θ and paying at date T + θ is written :
C(t, T, K, θ) = P(t, T + θ) [L(t, T, T + θ)N(d
1
) − KN(d
2
)] (47)
where
_
_
_
d
1
=
1
σ

T −t
ln
L(t, T, T + θ)
K
+
1
2
σ

T − t
d
2
= d
1
− σ

T − t
(48)
When is this formula justiﬁed ?
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 48 / 61
The BGM market model
6
Change of numeraire
7
The Black Formula
8
The BGM market model
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 49 / 61
The BGM market model
Model deﬁnition (I)
Original paper
Brace A., Gatarek D. and Musiela M. (1997). “The Market Model of
Interest Rate Dynamics”, Mathematical Finance, 7, 127–155.
Assumptions ans notations
Calendar 0 < T
0
< T
1
< . . . < T
M
.
M forward Libor rates (L(t, T
0
, T
1
), . . . , L(t, T
M−1
, T
M
) with tenor
θ
i
= T
i
− T
i −1
.
Notation : ∀i = 1, . . . , M, L
i
(t) = L(t, T
i −1
, T
i
)
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 50 / 61
The BGM market model
Model deﬁnition (II)
Dynamics of the forward Libor rates
Each forward Libor is assumed to be a martingale with respect to the
associated forward measure :
dL
i
(t)
L
i
(t)
= γ
i
(t)dW
i ,Q
T
i
(t) (49)
where γ
i
(t) is a deterministic function.
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 51 / 61
The BGM market model
No arbitrage condition
Proposition
In the BGM model, the no arbitrage condition gives the following
relationship between the volatilities γ
i
of the forward Libor and the
volatilities Γ
i
of the zero-coupon bonds P(t, T
i
):
γ
i
(t) =
1 + θ
i
L
i
(t)
θ
i
L
i
(t)

i
(t) −Γ
i −1
(t)] . (50)
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 52 / 61
The BGM market model
Pricing caplets
Proposition
In the BGM model, the price at time 0 of a post-paid caplet (strike K,
maturity T
i −1
on a Libor rate L(T
i −1
, T
i
) is given by:
C(0, T
i −1
, K, θ
i
) = P(0, T
i
) [L
i
(0)N(d
1
) − KN(d
2
)] (51)
where
_
¸
¸
_
¸
¸
_
d
1
=
1
v
ln
L
i
(0)
K
+
1
2
v
d
2
= d
1
−v
v =
_
T
i −1
0
γ
2
i
(t)dt
(52)
The volatility implied by the Black formula is then
σ
Black
imp
(L
i
) =
¸
1
T
i −1
_
T
i −1
0
γ
2
i
(t)dt (53)
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 53 / 61
The BGM market model
Specifying Libor volatilities (I)
Simple choice : constant volatilities
∀i = 1, . . . , M, γ
i
(t) = γ
i
constant. (54)
[0, T
0
] ]T
0
, T
1
] ]T
1
, T
2
] . . . ]T
M−2
, T
M−1
]
L
1
(t) γ
1
L
2
(t) γ
2
γ
2
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
L
M
(t) γ
M
γ
M
γ
M
. . . γ
M
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 54 / 61
The BGM market model
Specifying Libor volatilities (II)
Another simple choice : piecewise-constant volatilities
∀i = 1, . . . , M, γ
i
(t) = γ
i ,β(t)
constant. (55)
[0, T
0
] ]T
0
, T
1
] ]T
1
, T
2
] . . . ]T
M−2
, T
M−1
]
L
1
(t) γ
1,1
L
2
(t) γ
2,1
γ
2,2
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
L
M
(t) γ
M,1
γ
M,2
γ
M,3
. . . γ
M,M
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 55 / 61
The BGM market model
Specifying Libor volatilities (III)
Simpler : piecewise-constant volatility that depends only on the time to
maturity
∀i = 1, . . . , M, γ
i
(t) = γ
i ,β(t)
= η
i −(β(t)−1)
constant. (56)
[0, T
0
] ]T
0
, T
1
] ]T
1
, T
2
] . . . ]T
M−2
, T
M−1
]
L
1
(t) η
1
L
2
(t) η
2
η
1
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
L
M
(t) η
M
η
M−1
η
M−2
. . . η
1
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 56 / 61
The BGM market model
Specifying Libor volatilities (IV)
Parametric choices
One may also deﬁne Libor volatilities with ∀i = 1, . . . , M, :
γ
i
(t) = [a(T
i −1
− t) + d] e
−b(T
i −1
−t)
+ c (57)
or
γ
i
(t) = η
i
_
[a(T
i −1
− t) + d] e
−b(T
i −1
−t)
+ c
_
(58)
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 57 / 61
The BGM market model
Dynamics of the forward Libor rates under a unique
forward measure
Proposition
Let i ∈ {1, . . . , M}. The dynamics of the forward Libor rates L
i
(t) under
the forward measure Q
T
k
, k = 1, . . . , M is given by the following SDE:
if k < i ,
dL
i
(t)
L
i
(t)
= γ
i
(t)dW
i ,Q
T
k

i

j =k
ρ
ij
γ
i
(t)γ
j
(t)
θ
j
L
j
(t)
1 + θ
j
L
j
(t)
dt,
if k = i ,
dL
i
(t)
L
i
(t)
= γ
i
(t)dW
i ,Q
T
i
if k > i ,
dL
i
(t)
L
i
(t)
= γ
i
(t)dW
i ,Q
T
k
+
k

j =i +1
ρ
ij
γ
i
(t)γ
j
(t)
θ
j
L
j
(t)
1 + θ
j
L
j
(t)
dt.
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 58 / 61
The BGM market model
Introducing the spot Libor measure
Deﬁnition
The spot Libor numeraire is deﬁned as :
B(t) =
P(t, T
β(t)−1
)
β(t)−1

j =0
P(T
j −1
, T
j
)
(59)
Proposition
Under the spot Libor measure Q
B
associated with the numeraire B(t), the
dynamics of the foward Libor L
i
(t) is written:
dL
i
(t)
L
i
(t)
= γ
i
(t)dW
Q
B
+
i

j =β(t)
ρ
ij
γ
i
(t)γ
j
(t)
θ
j
L
j
(t)
1 + θ
j
L
j
(t)
dt. (60)
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 59 / 61
The BGM market model
Swap market model
Original paper
Jamshidian F. (1997). “LIBOR and swap market models and measures”,
Finance and Stochastics, 1 (4), 293–330.)
Model deﬁnition
A swap market models assumes that the swap rate S
α,β
is solution of the
SDE :
dS
α,β
(t)
S
α,β
(t)
= γ
α,β
(t)dW
Q
α,β
(t), (61)
where Q
α,β
is the measure linked with numeraire

β
i =α+1
τ
i
P(t, T
i
).
Compatibility with the Black formula for swaption
Theoretical inconsistency with the BGM market model
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 60 / 61
The BGM market model
Other LIBOR approaches
Markov-functional Libor models (Hunt P., Kennedy J. and Pelsser A.
(2000) “ Markov-functional interest rate models ”, Finance and
Stochastics, 4 (4), 391–408.)
Aﬃne Libor Models (Keller-Ressel M., Papapantoleon A., Teichmann
J. (2009). “A new approach to LIBOR modeling”)
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 61 / 61

Course outline

Lecture 1 Basic concepts and short rate models Lecture 2 From short rate models to the HJM framework Lecture 3 Libor Market Models Lecture 4 Practical aspects of market models - I (E.Durand, Soci´t´ G´n´rale) ee e e Lecture 5 Practical aspects of market models - II (E.Durand, Soci´t´ G´n´rale) ee e e

Ioane Muni Toke (ECP - OMA Finance)

Interest rates stochastic models

Dec. 2010 - Jan. 2011

2 / 61

Useful bibliography

This short course uses material from : Brigo D. and Mercurio F. (2006). Interest rates models - Theory and Practice, 2nd edition, Springer. Martellini L. and Priaulet P. (2000). Produits de taux d’int´rˆt, ee Economica. Shreve S. (2004). Stochastic Calculus for Finance II: Continuous-Time Models, Springer. Original research papers (references below).

Ioane Muni Toke (ECP - OMA Finance)

Interest rates stochastic models

Dec. 2010 - Jan. 2011

3 / 61

Jan. 2011 4 / 61 . 2010 .Part I Basic concepts Ioane Muni Toke (ECP .OMA Finance) Interest rates stochastic models Dec.

OMA Finance) . T ))(T −t) (3) Interest rates stochastic models Dec. T )(T − t) (2) Y (t.Jan. P(t. T ) : Price at time t of a T -maturity zero-coupon bond R(t. P(t. T ) : Continuously-compounded spot interest rate R(t. T ) = P(t. or short rate. T ) = P(t. T ) : Simply-compounded spot interest rate L(t. P(t. P(t. T ) = 1 − P(t. T ) = e −R(t.T )(T −t) T −t (1) L(t.e.e. T ) : Annually-compounded spot interest rate Y (t. 2010 . T )(T − t) 1 + L(t.Spot interest rates r (t) : Instantaneous (interbank) rate. 2011 5 / 61 Ioane Muni Toke (ECP . T ) 1 i. T ) = − ln P(t. T )1/(T −t) (1 + Y (t.e. T ) = 1 1 − 1 i. T ) i.

Jan. 1999. 2010 . Ioane Muni Toke (ECP . 2011 6 / 61 . Danmarks National Bank.Term structure of interest rates Reproduced from “Danish Government Borrowing and Debt 1998”.OMA Finance) Interest rates stochastic models Dec.

Jan. u)du t (5) Ioane Muni Toke (ECP . T ) = − ∂ ln P(t. 2010 . S) : Simply-compounded forward interest rate L(t. 2011 7 / 61 . S) = f (t. T . T ) −1 P(t. T . S) = 1 S −T P(t. S) i. T ) : Instantaneous forward interest rate f (t.e. T ) i. T ) = exp − ∂T P(t. T ) P(t. 1 + (S − T )L(t. P(t.Forward interest rates Forward-rate agreement : exchange of a ﬁxed-rate payment and a ﬂoating-rate payment L(t. T .OMA Finance) Interest rates stochastic models Dec.e. S) (4) T f (t.

β (t) = P(t. Ti ) (7) Link with simple forward rates Sα.Swap rates Exchange of ﬁxed-rate cash ﬂows and ﬂoating-rate cash ﬂows Exchanges at dates Tα+1 . . . Tα ) − P(t. Ti ) i =α+1 (6) Swap rate Sα. with τi = ti − Ti −1 Value at time t of a receiver swap : β Π RS (t. . Tβ ) + N τi KP(t.Tj−1 .Jan. 2011 . α. β.β (t) = Ioane Muni Toke (ECP .OMA Finance) β 1 j=α+1 1+τj L(t. Tα ) − P(t. 2010 .Tj ) i =α+1 τi 1− (8) 8 / 61 Interest rates stochastic models Dec. . K ) = −N(P(t. Tβ . N.Tj ) β i 1 j=α+1 1+τj L(t. Tβ ) β i =α+1 τi P(t.Tj−1 .

ﬂoors and swaptions Cap : Payer swap in which only positive cash ﬂows are exchanged Floor : Receiver swap in which only positive cash ﬂows are exchanged Caplet (ﬂoorlet) : One-date cap (ﬂoor).e.Caps. Ti ) − K ]+ . contract with payoﬀ at time T if T = Tα β + N i =α+1 τi P(Tα . 2011 9 / 61 . β) at maturity T . (9) Swaption : A European payer swaption is an option giving the right to enter a payer swap (α. Ti ) [L(Tα . contract with payoﬀ at time Ti Nτi [L(Ti −1 . Ti ) − K ] . Ti −1 .e. i. (10) Ioane Muni Toke (ECP . 2010 .Jan.OMA Finance) Interest rates stochastic models Dec. i.

OMA Finance) Interest rates stochastic models Dec.Part II Short-rate models Ioane Muni Toke (ECP .Jan. 2011 10 / 61 . 2010 .

OMA Finance) Interest rates stochastic models Dec. 2010 .Table of contents 1 The Vasicek model 2 The CIR model 3 The Hull-White (extended Vasicek) model Ioane Muni Toke (ECP .Jan. 2011 11 / 61 .

Jan.The Vasicek model Table of contents 1 The Vasicek model 2 The CIR model 3 The Hull-White (extended Vasicek) model Ioane Muni Toke (ECP . 2010 . 2011 12 / 61 .OMA Finance) Interest rates stochastic models Dec.

Dynamics of the short rate Short rate r (t) follows an Ornstein-Uhlenbeck process drt = κ[θ − rt ]dt + σdWt with κ.The Vasicek model Model deﬁnition Original paper Vasicek. (1977). 5 (2). θ. (11) Ioane Muni Toke (ECP . 177–188. O.Jan. “An equilibrium characterization of the term structure”. 2011 13 / 61 . σ positive constants. 2010 .OMA Finance) Interest rates stochastic models Dec. Journal of Financial Economics.

The Vasicek model Dynamics of the short rate Proposition In the Vasicek model. 2010 .Jan.OMA Finance) Interest rates stochastic models Dec. 2011 14 / 61 . Ioane Muni Toke (ECP . the SDE deﬁning the short rate dynamics can be integrated to obtain r (t) = r (s)e −κ(t−s) + θ(1 − e −κ(t−s) ) + σ t s e −κ(t−u) dWu (12) Short rate r (t) is normally distributed conditionally on Fs .

T ) = exp (θ − σ )(B(t.Jan. 2010 . the price of a zero-coupon bond is given by P(t.OMA Finance) Interest rates stochastic models Dec. T ) =  κ Explicit pricing formula. T )e −B(t. (13) (14) Ioane Muni Toke (ECP . T ) = A(t. T )2  2κ2 4κ −κ(T −t)  1−e  B(t. 2011 15 / 61 . T ) − (T − t)) − σ B(t.The Vasicek model Price of zero-coupon bonds Proposition In the Vasicek model.T )r (t) with  2 2   A(t.

OMA Finance) Interest rates stochastic models Dec. the continuously-compounded spot rate is written R(t. 2011 16 / 61 .Jan. T ) = R∞ +(rt −R∞ ) with R∞ = θ − σ2 1 − e −κ(T −t) + 3 (1−e −κ(T −t) )2 (15) κ(T − t) 4κ (T − t) σ2 2κ2 (16) Ioane Muni Toke (ECP .The Vasicek model Continuously-compounded spot rate Proposition In the Vasicek model. 2010 .

2011 17 / 61 .Jan.The CIR model Table of contents 1 The Vasicek model 2 The CIR model 3 The Hull-White (extended Vasicek) model Ioane Muni Toke (ECP .OMA Finance) Interest rates stochastic models Dec. 2010 .

θ. (1985). ”A Theory of the Term Structure of Interest Rates”.A. σ positive constants satisfying σ 2 < 2κθ.OMA Finance) Interest rates stochastic models Dec. Dynamics of the short rate Short rate is given by the following SDE √ drt = κ[θ − rt ]dt + σ rt dWt with κ. 2011 18 / 61 . Econometrica 53.E.. Ingersoll J. and Ross S.C. 385–407. (17) Ioane Muni Toke (ECP . 2010 .The CIR model Model deﬁnition Original paper Cox J.Jan.

the short rate r (t) follows a noncentral χ2 distribution Ioane Muni Toke (ECP . 2010 .OMA Finance) Interest rates stochastic models Dec. 2011 19 / 61 .The CIR model Dynamics of the short rate Proposition In the CIR model.Jan.

T ) =     B(t. 2010 . T ) = A(t.T )r (t) with      A(t. T ) =       γ = Ioane Muni Toke (ECP . T )e −B(t.OMA Finance) κ+γ 2κθ σ2 (18) 2γe 2 (T −t) 2γ + (κ + γ)(e γ(T −t) − 1) 2(e γ(T −t) − 1) 2γ + (κ + γ)(e γ(T −t) − 1) κ2 + 2σ 2 (19) Interest rates stochastic models Dec. the price of a zero-coupon bond is P(t.The CIR model Pricing of zero-coupon bonds Proposition In the CIR model.Jan. 2011 20 / 61 .

2011 21 / 61 .Jan.OMA Finance) Interest rates stochastic models Dec. 2010 .The Hull-White (extended Vasicek) model Table of contents 1 The Vasicek model 2 The CIR model 3 The Hull-White (extended Vasicek) model Ioane Muni Toke (ECP .

OMA Finance) Interest rates stochastic models Dec. Dynamics of the short rate Short rate is given by the following SDE drt = [b(t) − art ]dt + σdWt with a and σ positive constants. 2011 22 / 61 . Non-time-homogeneous extension of the Vasicek model. 2010 . (20) Ioane Muni Toke (ECP . ”Pricing interest-rate-derivative securities”.The Hull-White (extended Vasicek) model Model deﬁnition Original paper J Hull and A White (1990). 573–592.Jan. The Review of Financial Studies 3.

t) + σ2 (1 2a2 t s e −a(t−u) dWu (22) − e −at )2 . t) + (1 − e −2at ) (21) b(t) = ∂T 2a Dynamics of the short rate The short rate SDE can then be integrated to obtain : r (t) = r (s)e −a(t−s) + α(t) − α(s)e −a(t−s) + σ with α(t) = f M (0. t) + af M (0.The Hull-White (extended Vasicek) model Model deﬁnition Proposition This model can exactly ﬁt the term-structure observed on the market by setting σ2 ∂f M (0. Dec. 2010 .Jan.OMA Finance) Interest rates stochastic models . 2011 23 / 61 Ioane Muni Toke (ECP .

the price of a zero-coupon bond is given by P(t.T )r (t) with   A(t. T ) = σ2 P M (0. 2010 . T )2 P M (0. T ) = A(t. T ) =  (23)   B(t.OMA Finance) Interest rates stochastic models Dec. T )e −B(t.The Hull-White (extended Vasicek) model Price of zero-coupon bonds Proposition In the Hull-White model. t) 4a 1 −a(T −t) (1 − e ) a (24) Ioane Muni Toke (ECP . T ) exp B(t. t) − (1 − e −2at )B(t.Jan. 2011 24 / 61 . T )f M (0.

on a zero-coupon bond of maturity S > T .The Hull-White (extended Vasicek) model Price of options on a zero-coupon bond Proposition In the Hull-White model. S)N (q1 ) − KP(t. 2010 . T )N (q2 ) (25) with   σ T = σ 1−e −2a(T −t) B(T . S)  r  2a T P(t.T ) + σ2 T  r   T q2 = q1 − σr (26) Ioane Muni Toke (ECP . can be written HW CZC = P(t.Jan. 2011 25 / 61 .OMA Finance) Interest rates stochastic models Dec. the price of a european call option.S) r q1 = σ1 ln KP(t. with strike K and maturity T .

OMA Finance) Interest rates stochastic models Dec. 2010 .Part III From short rate models to HJM framework Ioane Muni Toke (ECP .Jan. 2011 26 / 61 .

OMA Finance) Interest rates stochastic models Dec. 2010 .Table of contents 4 Multifactor models 5 The HJM framework Ioane Muni Toke (ECP .Jan. 2011 27 / 61 .

Multifactor models Table of contents 4 Multifactor models 5 The HJM framework Ioane Muni Toke (ECP . 2011 28 / 61 .Jan. 2010 .OMA Finance) Interest rates stochastic models Dec.

Jan. Priaulet. (1996)) Ioane Muni Toke (ECP . Correlation in one-factor aﬃne term structure models Arbitrage in short/long rates models (Dybvig. Empirical studies : PCA on correlation matrix Reproduced from Jamshidian. 2010 . (1997). 2000. Zhu. Ingersoll.Multifactor models Motivations Empirical studies : correlations of interests rates by maturity Reproduced from Martellini. Ross.OMA Finance) Interest rates stochastic models Dec. Finance and Stochastics 1(1). 2011 29 / 61 . 43–67.

Multifactor models A Gaussian two-factor model (I) Model deﬁnition The short rate r (t) is written r (t) = x(t) + y (t) + φ(t). 2011 30 / 61 .OMA Finance) Interest rates stochastic models Dec. x(0) = 0. W2 φ(0) = r0 .Jan. t (28) = ρ and φ is a deterministic function such that Ioane Muni Toke (ECP . r (0) = r0 . (27) where the two factors x and y are solutions of the following SDEs : dx(t) = −ax(t)dt + σdW1 (t). with d W1 . y (0) = 0. dy (t) = −by (t)dt + ηdW2 (t). 2010 .

T ) if and only if φ is written φ(T ) = f M (0. T ) at time t of the T -maturity zero-coupon bond can be written P(t. 2011 31 / 61 Ioane Muni Toke (ECP .Multifactor models A Gaussian two-factor model (II) Price of a zero-coupon bond In the Gaussian two-factor model. 2010 .Jan. T )} 2 (29) Fitting the observed term structure The Gaussian two-factor model ﬁts the observed term structure P M (0.OMA Finance) . T )+ σ2 η2 ση (1−e aT )2 + 2 (1−e bT )2 +ρ (1−e aT )(1−e bT ) 2a2 2b ab (30) Interest rates stochastic models Dec. the price P(t. T ) = exp{− T 0 φ(u)du − 1−e −a(T −t) a x(t) − 1−e −b(T −t) b y (t) + 1 V (t.

T ) exp{−Ba (t. i (31) (32) First step allowing the modeling of correlations. T )y (t)} where    A(t. Ioane Muni Toke (ECP . T ) + V (0. T ) =    B (t.OMA Finance) Interest rates stochastic models Dec.Jan. T )x(t) − Bb (t.Multifactor models A Gaussian two-factor model (III) Pricing of zero-coupon bond In the Gaussian two-factor model. the price P(t. M (0. T ) = A(t. T ) at time t of the T -maturity zero-coupon bond can be written P(t. 2010 . T ) − V (0. t) P 2 1 − e −i (T −t) . T ) =  i 1 P M (0. 2011 32 / 61 . t))}. T ) exp{ (V (t.

Jan.The HJM framework Table of contents 4 Multifactor models 5 The HJM framework Ioane Muni Toke (ECP . 2010 . 2011 33 / 61 .OMA Finance) Interest rates stochastic models Dec.

The HJM framework Framework deﬁnition Original paper Heath D.Jan. T )dt + σ(t.OMA Finance) Interest rates stochastic models Dec. (33) Ioane Muni Toke (ECP . Econometrica 60. T ). 2010 . Jarrow R. Forward dynamics The instantaneous forward rates dynamics is given by the following SDE: df (t. 2011 34 / 61 . f (0. and Morton A.(1992). 77–105. T ) = f M (0. ”Bond Pricing and the Term Structure of Interest Rates: A New Methodology”. T )dWt .. T ) = α(t.

T )P(t.Jan.The HJM framework No arbitrage condition (I) Dynamics of the zero-coupon bond prices In a HJM framework. 2010 . T ) rt − α∗ (t. t Ioane Muni Toke (ECP . 2 (34) where  T  ∗  α (t.  t (35) T  ∗  σ (t. T ) + σ ∗ (t. T )2 dt−σ ∗ (t. T ) =  σ(t.OMA Finance) Interest rates stochastic models Dec. 2011 35 / 61 . T )dWt . T ) = P(t. T ) = α(t. the price of the T -maturity zero-coupon bond is solution of the following SDE: 1 dP(t. u)du. u)du.

T )P(t. T ) = σ(t.OMA Finance) Interest rates stochastic models Dec.Jan. T ) + θ(t)] (36) In this case. T ) = σ(t. T )dt + σ(t. there is no arbitrage if there exists a process (θt )0≤t≤T satisfying ¯ α(t. T )σ ∗ (t. T )dWtQ dP(t.The HJM framework No arbitrage condition (II) Dynamics of the zero-coupon bond prices In a HJM framework. 2010 . T )dWtQ (37) Ioane Muni Toke (ECP . 2011 36 / 61 . T )dt − σ ∗ (t. dynamics in the model can be rewritten under a risk-neutral measure Q : df (t. T ) = rt P(t. T ) [σ ∗ (t.

The HJM framework Markovianity in the HJM framework (I) Dynamics of the short rate In a no arbitrage HJM framework. 2011 37 / 61 .Jan. s)ds du + 0 σ(u. t) u σ(u. T ) = η(t)e − T t κ(u)du Ioane Muni Toke (ECP . t) + 0 σ(u.OMA Finance) Interest rates stochastic models Dec. T ) = ξ(t)φ(T ) Ritchken and Sankarasubramanian (1995) : σ(t. 2010 . t)dWu (38) Choice of volatilities to get a markovian model: Separation of variables : σ(t. the short rate can be written t t t r (t) = f (0.

2011 38 / 61 . every derivative product is completely determined by a two-dimensional Markov process if T and only if σ(t.OMA Finance) Interest rates stochastic models Dec.The HJM framework Markovianity in the HJM framework (II) Ritchken and Sankarasubramanian volatility (1995) In a 1D HJM framework with σ(t.Jan. Ioane Muni Toke (ECP . 2010 . T ) T -diﬀerentiable. T ) = η(t)e − t κ(u)du where η is an adapted process and κ is a deterministic and integrable process.

The HJM framework

Proposition If the SDE drt = b(t, rt )dt + γ(t, rt )dWt deﬁnes a short rate model with an aﬃne term structure P(t, T ) = A(t, T )e −B(t,T )r (t) , then this model ∂ belongs to the HJM framework with σ(t, T ) = ∂T B(t, T )γ(t, rt ). One can check that the Vasicek, CIR and Hull-White models are one-dimensional no-arbitrage HJM models.

Ioane Muni Toke (ECP - OMA Finance)

Interest rates stochastic models

Dec. 2010 - Jan. 2011

39 / 61

The HJM framework

Choices of volatility

Ho-Lee σ(t, T ) = σ Vasicek/Hull-White σ(t, T ) = γ(t)e −λ(T −t) (40) (constant) (39)

Ioane Muni Toke (ECP - OMA Finance)

Interest rates stochastic models

Dec. 2010 - Jan. 2011

40 / 61

The HJM framework

Pricing of caplet
Proposition In a no-arbitrage HJM framework, the price of a caplet of maturity T , strike K , paid in T + θ is written : C (t, T , K , θ) = P(t, T + θ) [(1 + θL(t, T , T + θ)N (d1 ) − (1 + θK )N (d0 )] (41) where  1 + θL(t, T , T + θ) 1 2 1   ln − Σ (t, T ) d0 =   Σ(t, T ) 1 + θK 2  d1 = d0 + Σ(t, T ) (42)  T    Σ(t, T ) =  (σ ∗ (u, T + θ) − σ ∗ (u, T ))2 du
t
Ioane Muni Toke (ECP - OMA Finance) Interest rates stochastic models Dec. 2010 - Jan. 2011 41 / 61

Part IV Libor market models Ioane Muni Toke (ECP . 2010 . 2011 42 / 61 .OMA Finance) Interest rates stochastic models Dec.Jan.

2011 43 / 61 .OMA Finance) Interest rates stochastic models Dec.Table of contents 6 Change of numeraire 7 The Black Formula 8 The BGM market model Ioane Muni Toke (ECP . 2010 .Jan.

Jan.Change of numeraire Table of contents 6 Change of numeraire 7 The Black Formula 8 The BGM market model Ioane Muni Toke (ECP .OMA Finance) Interest rates stochastic models Dec. 2011 44 / 61 . 2010 .

Xt QN XT F . t Nt = E NT QN is deﬁned by the Radon-Nikodym derivative dQN dQM Ioane Muni Toke (ECP .Jan.Change of numeraire General change of measure Theorem Assume there exists a numeraire (Mt )t≥0 and an equivalent measure QM such that the price of any traded asset X “discounted” by the process M M X X is a QM -martingale. Mtt = E Q MT Ft . i.OMA Finance) FT = NT M0 . i. T Let (Nt )t≥0 be a numeraire. 2010 . Then there exists an equivalent probability measure QN such that the price of any traded asset X “discounted” by N is a QN -martingale.e. 2011 (43) Interest rates stochastic models 45 / 61 . N0 MT Dec.e.

Change of numeraire Changing from risk-neutral measure Proposition Let Q be the risk-neutral measure associated with a riskless numeraire t β(t) = e 0 ru du . Nt )dt is a QN -brownian motion. Nt )dWtQ Then Xt Nt (44) (45) is a QN -martingale with dynamics : d N Xt Nt = Xt N σ X (t. 2011 46 / 61 . Nt ) σ N (t. Xt )dWtQ Let N be another traded asset : dNt = rt Nt dt + σ N (t.Jan. Xt ) − σ N (t. 2010 .OMA Finance) Interest rates stochastic models Dec. Ioane Muni Toke (ECP . Nt )dWtQ Nt (46) where dWtQ = dWtQ − σ N (t. Let X be a traded asset with Q-dynamics dXt = rt Xt dt + σ X (t.

2011 47 / 61 .The Black Formula Table of contents 6 Change of numeraire 7 The Black Formula 8 The BGM market model Ioane Muni Toke (ECP . 2010 .Jan.OMA Finance) Interest rates stochastic models Dec.

strike K ) on the θ-tenor Libor L(. T + θ)N (d1 ) − K N (d2 )] where    d1 = d2 L(t.. θ) = P(t. K .The Black Formula The Black formula Proposition The Black formula for a caplet (maturity T . 2011 48 / 61 . + θ and paying at date T + θ is written : C (t. T . 2010 .OMA Finance) Interest rates stochastic models Dec. T . . T + θ) [L(t. T . T + θ) 1 √ 1 + σ T −t ln K 2 σ T −t √ = d1 − σ T − t √ (48) (47) When is this formula justiﬁed ? Ioane Muni Toke (ECP .Jan.

2011 49 / 61 .Jan.The BGM market model Table of contents 6 Change of numeraire 7 The Black Formula 8 The BGM market model Ioane Muni Toke (ECP . 2010 .OMA Finance) Interest rates stochastic models Dec.

TM ) with tenor θi = Ti − Ti −1 . T1 ).OMA Finance) Interest rates stochastic models Dec. Ti −1 . Assumptions ans notations Calendar 0 < T0 < T1 < . . Notation : ∀i = 1.Jan. . TM−1 . . . M forward Libor rates (L(t. (1997). Li (t) = L(t. “The Market Model of Interest Rate Dynamics”.. . 7. . L(t. M. 127–155. . T0 . Mathematical Finance. 2010 . < TM . . . . and Musiela M. Ti ) Ioane Muni Toke (ECP . Gatarek D. 2011 50 / 61 .The BGM market model Model deﬁnition (I) Original paper Brace A.

Ioane Muni Toke (ECP .OMA Finance) Interest rates stochastic models Dec.Q i (t) Li (t) (49) where γi (t) is a deterministic function.The BGM market model Model deﬁnition (II) Dynamics of the forward Libor rates Each forward Libor is assumed to be a martingale with respect to the associated forward measure : T dLi (t) = γi (t)dW i . 2010 . 2011 51 / 61 .Jan.

Jan. the no arbitrage condition gives the following relationship between the volatilities γi of the forward Libor and the volatilities Γi of the zero-coupon bonds P(t. 2011 52 / 61 . 2010 .The BGM market model No arbitrage condition Proposition In the BGM model. Ti ): γi (t) = 1 + θi Li (t) [Γi (t) − Γi −1 (t)] . θi Li (t) (50) Ioane Muni Toke (ECP .OMA Finance) Interest rates stochastic models Dec.

θi ) = P(0. maturity Ti −1 on a Libor rate L(Ti −1 .The BGM market model Pricing caplets Proposition In the BGM model. 2010 . the price at time 0 of a post-paid caplet (strike K . Ti ) is given by: C (0.OMA Finance) Interest rates stochastic models .Jan. 2011 (53) 53 / 61 Ioane Muni Toke (ECP . Ti ) [Li (0)N (d1 ) − K N (d2 )] where    d1 =   d2   v 1 Li (0) 1 ln + v v K 2 = d1 − v T = 0 i −1 γi2 (t)dt (51) (52) The volatility implied by the Black formula is then Black σimp (Li ) = 1 Ti −1 0 Ti −1 γi2 (t)dt Dec. Ti −1 . K .

γM (54) Ioane Muni Toke (ECP . γM . . . γM ]T0 .... . . . 2010 . 2011 54 / 61 . . . .Jan. M. ..The BGM market model Specifying Libor volatilities (I) Simple choice : constant volatilities ∀i = 1. T0 ] γ1 γ2 . L1 (t) L2 (t) . . . . T2 ] dead dead . γi (t) = γi constant. ... γM ]T1 . . LM (t) [0.OMA Finance) Interest rates stochastic models Dec. .. . . T1 ] dead γ2 . . . ]TM−2 . .. TM−1 ] dead dead .

T2 ] dead dead . LM (t) [0.The BGM market model Specifying Libor volatilities (II) Another simple choice : piecewise-constant volatilities ∀i = 1. .Jan. .2 .. .3 . .. 2011 55 / 61 .1 γ2.1 . . . TM−1 ] dead dead . . γM. ..β(t) constant.. .2 ]T1 . . M. .M (55) Ioane Muni Toke (ECP . ]TM−2 . . . .. T1 ] dead γ2. γM..1 ]T0 .. .OMA Finance) Interest rates stochastic models Dec. γi (t) = γi . . T0 ] γ1. . γM. γM. 2010 . . L1 (t) L2 (t) . . ..

. . L1 (t) L2 (t) . LM (t) [0. ]TM−2 . 2010 .. 2011 56 / 61 . ηM ]T0 . T1 ] dead η1 . η1 (56) Ioane Muni Toke (ECP . . γi (t) = γi .Jan.. ... . . . . TM−1 ] dead dead . . . ηM−1 ]T1 .The BGM market model Specifying Libor volatilities (III) Simpler : piecewise-constant volatility that depends only on the time to maturity ∀i = 1. .. .. .. . . ηM−2 . . .β(t) = ηi −(β(t)−1) constant. . T0 ] η1 η2 ..OMA Finance) Interest rates stochastic models Dec. . M. T2 ] dead dead . .

.The BGM market model Specifying Libor volatilities (IV) Parametric choices One may also deﬁne Libor volatilities with ∀i = 1. . .OMA Finance) Interest rates stochastic models Dec. 2010 . M.Jan. 2011 57 / 61 . : γi (t) = [a(Ti −1 − t) + d] e −b(Ti −1 −t) + c or γi (t) = ηi [a(Ti −1 − t) + d] e −b(Ti −1 −t) + c (58) (57) Ioane Muni Toke (ECP . .

OMA Finance) Interest rates stochastic models Dec. The dynamics of the forward Libor rates Li (t) under the forward measure QTk . . 2010 . . . . . .Q k + Li (t) i ρij γi (t)γj (t) j=k θj Lj (t) dt.Q k − Li (t) T dLi (t) = γi (t)dW i . if k > i . . 2011 58 / 61 .Jan. . 1 + θj Lj (t) k ρij γi (t)γj (t) j=i +1 θj Lj (t) dt.Q i Li (t) T dLi (t) = γi (t)dW i .The BGM market model Dynamics of the forward Libor rates under a unique forward measure Proposition Let i ∈ {1. 1 + θj Lj (t) Ioane Muni Toke (ECP . k = 1. T dLi (t) = γi (t)dW i . if k = i . M is given by the following SDE: if k < i . M}.

Jan. Tβ(t)−1 ) β(t)−1 (59) P(Tj−1 . 2011 (60) Interest rates stochastic models 59 / 61 . Tj ) j=0 Proposition Under the spot Libor measure QB associated with the numeraire B(t). 2010 .OMA Finance) i ρij γi (t)γj (t) j=β(t) θj Lj (t) dt.The BGM market model Introducing the spot Libor measure Deﬁnition The spot Libor numeraire is deﬁned as : B(t) = P(t. 1 + θj Lj (t) Dec. the dynamics of the foward Libor Li (t) is written: dLi (t) B = γi (t)dW Q + Li (t) Ioane Muni Toke (ECP .

2011 60 / 61 .β (t)dW Q (t). Finance and Stochastics. Sα. (1997).Jan.β (61) = γα.) Model deﬁnition A swap market models assumes that the swap rate Sα. Compatibility with the Black formula for swaption Theoretical inconsistency with the BGM market model Ioane Muni Toke (ECP .β (t) α. 2010 . 1 (4). Ti ). 293–330.β (t) where Qα.OMA Finance) Interest rates stochastic models Dec. “LIBOR and swap market models and measures”.The BGM market model Swap market model Original paper Jamshidian F.β is the measure linked with numeraire β i =α+1 τi P(t.β is solution of the SDE : dSα.

2010 .) Aﬃne Libor Models (Keller-Ressel M. 2011 61 / 61 . 391–408.The BGM market model Other LIBOR approaches Markov-functional Libor models (Hunt P. (2000) “ Markov-functional interest rate models ”.Jan.. Finance and Stochastics. 4 (4).. Papapantoleon A. Teichmann J.. (2009). and Pelsser A.OMA Finance) Interest rates stochastic models Dec. Kennedy J. “A new approach to LIBOR modeling”) Ioane Muni Toke (ECP .