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Vasickek Model

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Vasickek Model

Attribution Non-Commercial (BY-NC)

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Based on Notes by Robert Kohn, Courant Institute, NYU

Continuous Time Finance Lecture 10

Wednesday, March 30th, 2005

The Short Rate Dynamics

The Vasicek model describes the short rates Q dynamics by the following SDE:

dr

t

= ( ar

t

) dt + dw

t

(1)

where , a > 0, and are constants.

An explicit formula for r

t

: Start with:

d(e

at

r

t

) = e

at

dr

t

+ ae

at

r

t

dt = e

at

dt + e

at

dw

t

,

so:

e

at

r

t

= r

0

+

_

t

0

e

as

ds +

_

t

0

e

as

dw

s

.

Simplifying:

r

t

= r

0

e

at

+

a

(1 e

at

) +

_

t

0

e

a(ts)

dw

s

. (2)

2

Recall

r

t

= r

0

e

at

+

a

(1 e

at

) +

_

t

0

e

a(ts)

dw

s

. (3)

As the starting time is arbitrary:

r

t

= r

s

e

a(ts)

+

a

(1 e

a(ts)

) +

_

t

s

e

a(t)

dw

. (4)

(??) implies that r

t

is Gaussian at each t, with

expectation:

E

Q

[r

t

] = r

0

e

at

+

a

(1 e

at

), and

variance:

Var

Q

[r

t

] =

2

E

_

__

t

0

e

a(ts)

dw(s)

_

2

_

=

2

_

t

0

e

2a(ts)

ds =

2

2a

(1e

2at

).

3

Dynamics of Bond Price

We now show that the bond price is lognormally distributed in the Vasicek model:

By denition of the risk-neutral measure Q, the zero coupon bond price is:

P

t

(T) = E

Q

_

e

_

T

t

r(s) ds

| F

t

_

. (5)

From (??), (interchanging t, s)

P

t

(T) = A(t, T)e

B(t,T)r

t

(6)

B(t, T) =

_

T

t

e

a(st)

ds, and

A(t, T) = E

_

e

_

T

t

{

a

(1e

a(st)

)+

_

s

t

e

a(s)

dw()

}

ds

_

.

A(t, T), B(t, T) deterministic, r

t

Gaussian P

t

(T) lognormal.

4

Explicit Bond Pricing Formula

Can evaluate A(t, T), B(t, T) - see Lamberton & Lapeyre, pages 128-129.

Alternative approach: use P

t

(T) = V (t, r

t

), where V (t, r) solves BVP consisting of

PDE:

V

t

+ ( ar)V

r

+

1

2

2

V

rr

= rV

subject to the nal-time condition V (T, r) = 1 for all r.

Guess a solution of the form:

V (t, r; T) = A(t, T)e

B(t,T)r

.

5

Considered as functions of t, A(t, T) and B(t, T) solve the ODEs:

A

t

AB +

1

2

2

AB

2

= 0 and B

t

aB + 1 = 0

subject to:

A(T, T) = 1 and B(T, T) = 0.

Get:

B(t, T) =

1

a

(1 e

a(Tt)

)

and:

A(t, T) = exp

__

a

2

2a

2

_

(B(t, T) T + t)

2

4a

B

2

(t, T)

_

.

6

Term Structure and Volatility

Only three parameters special term structure.

By denition, the initial instantaneous forward rate curve f

0

(T) =

ln P

0

(T)

T

.

After some calculations, in the Vasicek model, one has:

f

0

(T) =

a

+ e

aT

_

r

0

a

_

2

2a

2

(1 e

aT

)

2

.

Volatility of f, (t, T) is dened by

df

t

(T) = (stu) dt + (t, T) dw

t

.

ln P

t

(T) = ln A(t, T) B(t, T)r

t

, implies

f

t

(T) =

T

ln A(t, T) +

T

B(t, T)r

t

,

Itos formula gives:

(t, T) =

T

B(t, T) = e

a(Tt)

.

7

Validity of Blacks Formula

We now show that P

t

(T) is lognormal under the forward-risk-neutral measure Q

T

.

(The measure under which tradeables normalized by P(t, T) are martingales.)

Already know that P

t

(T) is lognormal under the risk-neutral measure Q, but here

were interested in a dierent numeraire.

Change-of-numeraire in the one-factor setting:

The risk-neutral measure is associated with the risk-free money-market account

as numeraire (by denition d

t

= r

t

t

dt with

0

= 1).

Say N is another numeraire, and Q is the associated equivalent martingale mea-

sure.

Only positive tradeables can be numeraires, so the risk-neutral process for N is

dN

t

= r

t

N

t

dt +

N

t

N

t

dw

t

where

N

t

is in general stochastic and w is a Q standard Brownian motion.

8

Itos formula gives:

d

_

t

N

t

_

=

t

d(N

1

t

) + N

1

t

d

t

After some algebra:

d

_

t

N

t

_

=

t

N

t

(

N

t

)

2

dt

t

N

t

N

t

dw

t

.

t

N

t

is a Q-martingale, i.e.

d

_

t

N

t

_

=

t

N

t

N

t

dw

t

where w is a Q-Brownian motion.

Therefore:

dw

t

=

N

t

dt + dw

t

.

9

What is the SDE for the short rate in the Vasicek model under the forward-risk-neutral

measure Q

T

?

Numeraire is P

t

(T) = A(t, T)e

B(t,T)r

t

Ito the (uusal lognormal) volatility of P

t

(T) is B(t, T).

The preceding calculation gives:

dw

t

= B(t, T) dt + dw

t

.

Conclusion:

dr

t

= ( ar

t

) dt + dw

t

= [ ar

t

2

B(t, T)] dt + dw

t

,

where w is a Q

T

standard Brownian motion.

This SDE shows that short rates are normal and bond prices are lognormal, as under

the risk-neutral measure Q.

10

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