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Interest Rate Models: Vasicek

Peter Carr Bloomberg LP and Courant Institute, NYU


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)
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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
).
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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.
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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
.
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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)
_
.
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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)
.
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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.
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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
.
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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.
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