Chapter 5

Short Rate Model

The Black models presented in the previous chapter assume the underlying inter-
est rate or bond price has a lognormal distribution. Even with this assumption,
one can only use these models to price European option that is contingent on
only one particular rate (or price). For interest rate instruments that are sensi-
tive to the path of rate movements, or options that are contingent on the values
of more than one rate, as well as options with early exercise features, one would
need to model the dynamic of the entire term structure.

5.1 Instantaneous short rate and bond price

The short rate rt is a continuous time concept and applies to an infinitesimally
short period of time. A short rate model specifies the process for the short rate
rt and bond prices are derived given a specific spot rate process.
r0 r1 r2 rt rt+1 rT

0 1 2 ... t t+1 ... T

Under the periodic risk neutral measure

UT h i
Bt,T = EtQ e t ru du = EtQ er(T t) . (5.1)

c
If rt,T is the continuously compounded interest rate for the period t to T , then
c
Bt,T = ert,T (T t)
1 1 h i
c
rt,T = ln Bt,T = ln EtQ er(T t) .
T t T t
Short rate model, as it is developed in the literature, can be classified into
equilibrium and no-arbitrage models. Equilibrium models are also referred to as
endogenous term structure models because the term structure of interest rates
is an output of, rather than an input to, these models. If we have the initial
zero-coupon bond curve from the market, the parameters of the equilibrium
models are chosen such that the models produce a zero-coupon bond curve as
close as possible to the one observed in the market. Vasicek (1977) is the earliest

81
82 CHAPTER 5. SHORT RATE MODEL

and most famous general equilibrium short rate model. Since the equilibrium
models cannot reproduce exactly the initial yield curve, most traders have very
little confidence in using these models to price complex interest rate derivatives.
Hence, no-arbitrage models designed to exactly match the current term structure
of interest rates are more popular. It is not possible to arbitrage using simple
interest rate instruments in this type of no-arbitrage models.
Two of the most important no-arbitrage short-rate models are the Hull-
White model (1990) and the Black-Karasinski (1991) model. The spot rates
and bond prices, together, are used to price derivatives such as caps, floors and
swaptions. The spot rate models can also be broadly divided into Gaussian
and lognormal models. The former includes Vasicek (1977) and Hull and White
(1990, 1994), whereas the latter includes Black and Karasinski (1991) and Pe-
terson, Stapleton and Subrahmanyam (2003). Vasicek (1977) is the only general
equilibrium model that we describe in detail here.

5.2 The Vasicek model

In the Vasicek (1977) model, the risk neutral process for r is
drt = a[ rt ]dt + dWt , (5.2)
where r0 (at t = 0), a, and are positive constants. This model is an Ornstein-
Uhlenbeck process. This is the first interest rate model that incorporates mean
reversion. The parameter, , determining the overall level of volatlity. The
mean reversion parameter, a, determines the relative volatilities of long and
short rates. A high value of a causes short-term rate movements to damp out
quickly, so long-term volatility is reduced. The probability distribution of all
rates at all time is normal. However, with the normal distribution assumption,
short rates can be negative with positive probability, which is a major drawback
of the Vasicek model. Nevertheless, the analytic tractability resulting from the
Gaussian distribution is the biggest attraction of this model.
Let Xt = eat rt and use Itos lemma and Itos isometry, we derive (see exercise
2) by integrating (5.2)
h i Z t
rt = rs ea(ts) + 1 ea(ts) + ea(tu) dWu , for t s
s

where the distribution of the short rate is Gaussian with mean and variance,

E (rt ) = rs ea(ts) + 1 ea(ts) , (5.3)
2 h i
V ar (rt ) = 1 e2a(ts) (5.4)
2a
From equation (5.3), we can see that as t , E (rt ) . Thus short rate r
is mean reverting and can be regarded as the long-term level of the short rate.

5.2.1 ZC Bond price

From (5.1), Vasicek shows that the time t price of a zero coupon bond that
mature at T is
Bt,T = t,T et,T rt , (5.5)
5.2. THE VASICEK MODEL 83

where
1h i
t,T = 1 ea(T t) , (5.6)
a " #

(t,T T + t) a2 0.5 2 2 t,T
2
t,T = exp . (5.7)
a2 4a
h . i
3
For the limiting case when a = 0, t,T = T t, and t,T = exp 2 (T t) 6 .
Use the fact that
c 1
rt,T = ln Bt,T
T t
we have
c 1 1
rt,T = ln t,T + t,T rt .
T t T t

5.2.2 Terminal measure and bond options

Brigo (2006) shows, under the terminal measure QT , the dynamic in (5.2) be-
comes

drt = a t,T 2 art dt + dWtQT , (5.8)
dWtT = dWt + t,T dt

where, as before, t,T = a1 1 ea(T t) .
For s t T ,
Z t
rt = rs ea(ts) + Ms,t
T
+ ea(tu) dWuQT
s

with
h i
T 2 2 h i
Ms,t = 2 1 ea(ts) + 2 ea(T t) ea(T +t2s) .
a 2a
So under this forward QT measure,

EtQT (rt ) = rs ea(ts) + Ms,t

T

2 h i
V artQT (rt ) = 1 e2a(ts)
2a
and the price at time t of a call option that matures at time T on a zero-coupon
bond maturing at time S can be calculated as
+
cB
t = B E
0,T t
QT e
B T,S X
Z
= B0,T BeT,S X f (e rT ) drT
X

Since all rates are increasing function of r, all bond prices are decreasing function
of r. This means that the coupon-bearing bond is worth more than X and the
call option should be exercised if and only if r < r , where r is the rate that
makes BT,S = X.
84 CHAPTER 5. SHORT RATE MODEL

Jamshidian (1989) shows that the closed form solution of this call price is

cB
t = A Bt,S N (h) X Bt,T N (h P ), (5.9)

where S > T is the maturity date of the bond, T > t is the maturity date of
the option, A is the principal value of the bond, X is the strike price, and
1 A Bt,S P
h= ln + ,
P X Bt,T 2
r
h i 1 e2aT
P = 1 ea(ST ) .
a 2a

when a = 0, P = (S T ) T .
The price of a put option of the same term is

pB
t = X Bt,T N (h + P ) A Bt,S N (h) (5.10)

Equations (5.9) and (5.10) are essentially the same as Blacks model for
pricing bond options. The bond price volatility is P / T and the standard
deviation of the logarithm of the bond price at time T is P . Equations (5.9)
and (5.10) can be used to price caplets and floorlets since the latter can be
viewed as option on zero coupon bonds (see Section 4.3.3). An interest rate
cap or floor can also be valued using equations (5.9) and (5.10) since cap and
floor are simply portfolios of options on zero-coupon bonds.

5.2.3 The weakness of the Vasicek model

Equilibrium models such as the Vasicek model assumes that the term structure
is an output rather than an input. So typically, an optimisation routine is run
to fit a, and so that the model yield curve is as close as possible to the one
observed in the market. Not only that the fit is not likely to be perfect, some
shape of the yield curve (e.g. the inverted shape) can never be reproduced by
the Vasicek model no matter what the parameter values are. Moreover, the
Vasicek model has no control over the volatility term structure; the volatility
term structure of the Vasicek model is always monotonically downward sloping.
There are other equilibrium models, such as Brennan and Schwartz (1979)
and Longsta and Schwartz (1992), that are more flexible than Vasicek. But
none of the equilibrium models can fit the bond term structure exactly. Traders
find this rather unsettling as a 1% error in the price of the underlying bond can
result in a 25% error in the option price.
5.3. THE HULL-WHITE MODEL 85

5.3 The Hull-White Model

As mentioned in the introduction, the Hull and White (1990) model is one of the
no-arbitrage models that is designed to be exactly consistent with the observed
bond prices or the term structure of interest rates. In another words, in an
equilibrium model the term structure of interest rate is an output, whereas in
a no-arbitrage model, the term structure of interest rate is an input. Accord-
ing to the Hull-White model, also referred to as the extended-Vasicek model,
the instantaneous short-rate process evolves under the risk-neutral measure as
follows:
drt = [t art ]dt + dW, (5.11)
where a and are constant. The time deterministic function t is chosen so that
the model fits the initial term structure of interest rates. Hence, the Hull-White
(1990) model can be characterized as Vasicek model with a time dependent
reversion level.
Assuming that the term structure of zero coupon bond price that is currently
observed in the market is given by a suciently smooth function B0,t . Then
the market instantaneous forward rates associated with the bond price are
Ut
B0,t = e 0
f0,u du
or f0,t =
ln B0,t .
t
where f0,t is the instantaneous forward rate for a maturity t as seen at time zero.
The t in (5.11) function can be calculated from the initial term structure as
follows:
2
t = f0,t + a f0,t + 1 e2at (5.12)
t 2a
The third term of (5.12) is very small, and if we omit the third term, we can see
that it is the slope of the initial instantaneous forward curve that determines
the reversion level.
The other two parameters, a and , in (5.11) could also be made time-varying
enabling the model to be fitted to the initial volatility of all zero coupon rates
and to the volatility of short rate at all future times.1 However, Hull and
White (1996) note that while at and t allow the model to be fitted to the
volatility structure at time zero, the resulting volatility term structure could
be non-stationary in the sense that the future volatility structure implied by
the model can be quite dierent from the volatility structure today. On the
contrary, when these two parameters are kept constant, the volatility structure
stays stationary but models consistency with market prices of e.g. caps or
swaptions can suer considerably. Thus, there is a trade-o between tighter fit
and model stationarity. In practice, one could set at = a and let t follow some
parametric form. We will elaborate this in the next chapter when we introduce
the extension to short rate models.
As in the Vasicek model, equation (5.11) can be integrated to give
Z t Z t
rt = rs ea(ts) + ea(tu) u du + ea(tu) dWu
s s
Z t
a(ts) a(ts)
= rs e + t s e + ea(tu) dWu
s
1 The initial volatility of all rates depends on (0) and a(t). The volatility of short rate at
future times is determined by (t) (Hull and White 1996, p.9).
86 CHAPTER 5. SHORT RATE MODEL

where
2 2
t = f0,t +
2
1 eat . (5.13)
2a
Hence, rt is normally distributed with mean and variance
E (rt ) = rs ea(ts) + t s ea(ts) , (5.14)
2 h i
V ar (rt ) = 1 e2a(ts) , for t s. (5.15)
2a
Notice that if we define the process x by
dxt = axt dt + dWt with x0 = 0 (5.16)
then for each t > s
Z t
xt = xs ea(ts) + ea(tu) dWu
s

so that we can write

rt = xt + t (5.17)
for each t. This specification turns out to be very useful for working on the QT
measure and for model implementation. We will illustrate this second point in
the next Chapter.

5.3.1 Bond price

The Hull-White dynamic in (5.11)
is also very tractable for pricing derivative
UT
written on Bt,T = EtQ e t ru du . Due to the Gaussian distribution of rT , the
RT
integral t ru du itself is normally distributed with
Z T
ru du N (t,T , Vt,T )
t
B0,t 1
t,T = t,T (rt t ) + ln + (V0,T V0,t )
B0,T 2
1h i
t,T = 1 ea(T t)
a
2 2 a(T t) 1 2a(T t) 3
Vt,T = 2 T t+ e e .
a a 2a 2a
So we obtain analytical expression for bond price
Bt,T = t,T et,T rt ,
where
1h i
t,T = 1 ea(T t) ,
a
B0,T 2 2 2at
t,T = exp t,T f0,t 3 eaT eat e 1 .
B0,t 4a
Given the parameter values a and , the remaining three values B0,t , B0,T and
f0,t can be derived from the current term structure in order to calculate the
time t bond price Bt,T .
5.3. THE HULL-WHITE MODEL 87

5.3.2 Terminal measure and bond options

To price European bond option, we can follow the procedure in Section 5.2.2
(on Vasicek) to derive the distribution under QT measure. Here, we will use
the dynamic in (5.16) instead of (5.11) noting the fact that they are equivalent
measures linked by the Radon-Nikodym derivative t . Since the process x
corresponds to the Vasicek r with = 0, we can use (5.8) to get

dxt = t,T 2 axt dt + dWtQT ,
dWtT = dWt + t,T dt.

For s t T ,
Z t
xt = xs ea(ts) + Ms,t
T
+ ea(tu) dWuQT
s

with
T 2 h a(ts)
i 2 h a(T t) a(T +t2s)
i
Ms,t = 1 e e e .
a2 2a2
It is then easy to verify that

EtQT (rt ) = EtQT (xt + t ) = xs ea(ts) + Ms,t T

+ t
2 h i

V artQT (rt ) = V artQT (xt ) = 1 e2a(ts)
2a
which are the same as Vasicek. Hence, the Vasicek and the HW lead to the
same option pricing formulae (5.9) and (5.10) for ZC bond options.
From (4.4), the caplet can be priced as a put option on ZC bond, whereas
floorlet can be priced as a call option on ZC bond:

Caplett = (1 + k) pB
t

F loorlett = (1 + k) cB
t

Then cap and floor can be priced as the sum of caplets and floorlets respectively.
88 CHAPTER 5. SHORT RATE MODEL

5.4 Options on Coupon Bonds

In a one-factor model of the short rate, all zero-coupon bonds move up (down)
in price when r decreases (increase). As a result, a one-factor model allows us
to express a European option on a coupon-bearing bond as the sum of European
options on zero-coupon bonds. All the Gaussian class single factor models that
have analytical form of bond prices allow options on zero-coupon bonds to be
valued analytically. This includes the Vasicek and Hull-White models. Jamshid-
ian (1989) shows how European option on coupon bearing bond with strike price
c
X and maturity T can be priced. Let BT,S n
be the time T price of a coupon
bond that pays n coupons, after the option maturity, at Si = S1 , S2 , , Sn .
Let rT be the short rate at time T . The procedures for pricing the coupon-bond
option for both the Vasicek and the Hull-White models are as follows:

(i) Derive (through search iterative procedure) r , the critical value of rT for
c
which the price of the coupon-bearing bond, BT,S n
, equals the strike price
of the option.

(ii) If BT,Si
is the time T value of a ZC bond that mature at Si when the
spot rate is r , then strip the coupon bond into a series of ZC bonds, and

derive their bond prices BT,S i
, for Si = S1 , S2 , , Sn .

(iii) Calculate the prices of options cB

t on each of the ZC bonds that comprises

the coupon-bearing bond. Set the strike price equal to BT,S i
for the ZC
bond that mature at Si .
(iv) Then the price of the coupon-bond option is the sum of options on ZC
bonds: n
c X
cB
t (T, X) = cB
t T, Si , BT,Si
i=1

where cB
t

T, Si , BT,Si

is the price of option on BT,Si
with option maturity
T.

Similarly, the European swaptions can be priced as an option on a coupon

bearing bond.

Example 7 (Vasicek coupon bond option, Hull 5th ed. page 542) Suppose that
a = 0.1, = 0.1, and = 0.02 in the Vasicek model with the initial value of the
short rate being 10% per annum. Calculate the price of a three-year European
put option with a strike price of $98 on a bond that will mature in five years.
Suppose that the bond has a principal of $100 and pays a coupon of $5 every six
months.
5.4. OPTIONS ON COUPON BONDS 89

Given the option mature at T = 3, the coupon bond could be regarded as

the sum of four ZC bonds maturing at T = 3.5, 4, 4.5 and 5 with ZC bond cash
flows $5, $5, $5 and $105 respectively. If the short-term interest rates is rT at
the end of the three years, the value of the bond is, from equation (5.5),
c
BT,Sn
= 53,3.5 e3,3.5 rT + 53,4 e3,4 rT + 53,4.5 e3,4.5 rT + 1053,5 e3,5 rT

Using the expression for t,T in (5.6) and t,T in (5.7), we obtain
c
BT,Sn
= 5 0.9988e0.4877rT + 5 0.9952e0.9516rT + 5 0.9895e1.3929rT
+ 105 0.9819e1.8127rT

Now apply the procedures described above:

(i) Find r , the value of rT for which the bond price BT,S c
n
equal the strike
price of $98. One could use the excel solver or an interactive search routine
and get r = 0.10952.

(ii) When step (i) is done, we would have obtained BT,Si
for the four ZC
bonds underlying the coupon bond

B3,3.5 = 4.734, B3,4 = 4.484, B3,4.5 = 4.248, B3,5 = 84.535

which are used as the strike price for the following put options pB
0 T, Si , BT,Si :

pB
0 3, 3.5, B3,3.5 = 4.734 = 0.0125

pB
0 3, 4, B3,4 = 4.484 = 0.0228

pB
0 3, 4.5, B3,4.5 = 4.248 = 0.0314

pB
0 3, 5, B3,5 = 84.535 = 0.8084

To illustrate the calculation, take the last put option for example, given ,
a = 0.1, = 0.1, = 0.02, r = 0.1, A = 105 and X = 105;

B0,3 = 0.9614e2.5918 = 0.7419

B0,5 = 0.9489e2.9531 = 0.6101
r
h a(53)
i 1 e6a
P = 1e = 0.05445
a 2a
1 105 0.6101 P
h= ln + = 0.4161
P 84.534 0.7419 2
N (h) = 0.33864
N (h + P ) = 0.35878
pB
0 (3, 5, 84.535) = 84.535 0.7419 0.35878 105 0.6101 0.33864
= 0.8084

So the value of the option on the coupon bond is

4
X
c
pB
0 (T, X) = pB
0 T, Si , BT,Si
i=1
90 CHAPTER 5. SHORT RATE MODEL

5.5 The Black-Karasinski Model:

A model that addresses the negative interest rate issue of the Hull-White model
is the Black and Karasinski (1991) model. In this model, the risk neutral process
for logarithm of the instantaneous spot rate, ln rt is

d ln rt = [t at ln rt ] dt + t dz, (5.18)

where r0 (at t = 0) is a positive constant, t , at and t are deterministic functions

of time. Equation (5.18) shows that the instantaneous short rate evolves as the
exponential of an Ornstein-Uhlenbeck process with time-dependent coecients.
Again, the function t is chosen so that the model fits the initial term structure
of interest rates. Functions at and t are chosen so that the model can be fitted
to the market volatility curves. Based on the arguments given in Section 5.3,
we can also have the constant parameter version of (5.18) by setting at = a and
t = , which leads to

d ln rt = [t a ln rt ]dt + dz. (5.19)

As before, the coecient a measures the speed at which ln rt tends towards its
long-term value, t . Note that , denoting the volatility of the instantaneous
spot rate, must not be confused either with the volatility of the forward rate or
the volatility of the forward swap rate that are used in the Black formulae for
caplet/floorlet and swaptions, respectively.
From (5.19), by Ito lemma, we get

1 2
drt = rt t + a ln rt dt + rt dWt .
2

For each s t,
Z t Z t
a(ts) a(tu)
ln rt = ln rs e + e u du + ea(tu) dWu .
s s

Hence, rt is lognormally distributed with

Z t i
2 h
Es (rt ) = exp ln rs ea(ts) + ea(tu) u du + 1 e2a(ts)
s 4a
Z t i
2 2 h
Es rt = exp 2 ln rs ea(ts) + 2 ea(tu) u du + 1 e2a(ts)
s a
Moreover, setting
Z t
t = ln r0 eat + ea(tu) u du
0

2
lim E (rt ) = exp lim t +
t t 4a

This limit cannot be computed analytically except through numerical scheme.

The Black-Karasinski (1991) model is not analytically tractable. This ren-
ders the model calibration more burdensome as compared with e.g. Hull-White
model. With Hull-White model, when we have simulated rT , we can easily
5.6. YIELD CURVE AND VOLATILITY TERM STRUCTURE 91

compute bond price BT,s using the analytical formula. However, the desirable
feature is not shared by the Black-Karasinski model. When we have simu-
lated rT , we still need to compute BT,s numerically (e.g. using a tree) for each
simulated realization of rT .
A further, and more fundamental, drawback of the model is that the expected
1
value of the money market account B0,1 B eT 1,T
e1,2 B is infinite no matter
which maturity is considered as a consequence of the lognormal distribution of
r. This means the price of a Eurodollar future is infinite too. In practice, this
problem is partially overcome when using an approximating tree. With the
finite number of states, we get a finite expectation.

5.6 Yield Curve and Volatility Term Structure

It is well know that the Vasicek model can produce yield curves that are upward
sloping, downward sloping as well as a hump shape. But, the Vasicek model can-
not produce an inverted yield curve. The Hull-White and the Black-Karasinski
models, however, are designed to capture the current term structure exactly.
As far as the volatility term structure is concerned, the Vasicek model assume it
is a constant for all interest rates of all maturities. In the one-factor Hull-White
and the Black-Karasinski models, the eect of mean reversion is to cause the
volatility to be a declining function of maturity. This is not satisfactory as
the empirically observed volatility term structure usually has a hump between
short and medium terms. The two-factor versions of Hull-White and the Black-
Karasinski can produce this volatility hump. In Hull-White (1994), where
the volatility of the one-factor short-rate model is allowed to be time varying,
the model volatility term structure can have a humped shape also. We will
discuss these extensions in the next Chapter.
92 CHAPTER 5. SHORT RATE MODEL

5.7 Strengths and Weaknesses of Short Rate Mod-

els (From Haugh)
Short-rate models have a number of strengths and weaknesses.
Strengths:

(i) The models are generally tractable and very amenable to numerical and
Monte-Carlo simulation methods.
(ii) Derivatives prices can be computed quickly. This is very important for
risk-management purposes when many securities need to be priced fre-
quently.
(iii) They are parsimonious and can provide sanity checks on more sophisti-
cated models that can often be calibrated to fit everything. Models that
are calibrated to fit everything can be unreliable due to the problems as-
sociated with over-fitting. Of course short rate models with deterministic
time-varying parameters (e.g. Ho-Lee, Hull and White) are also suscepti-
ble to over-fitting.

Weaknesses:

(i) The one-factor short-rate models imply that movements in the entire term-
structure can be hedged with only two securities. Equivalently, instanta-
neous returns on zero-coupon bonds of dierent maturities are perfectly
correlated in single-factor models. Neither of these features is realistic
but these problems can be overcome by using multi-factor models. In fact
models with just 2 or 3 factors can aord considerably more modelling
flexibility. Moreover, they generally retain their numerical tractability.
Models with 3 or more factors, however, tend to suer from the curse-
of-dimensionality in which case Monte-Carlo simulation becomes the only
practical pricing technique.
(ii) They are not as close to reality as the LIBOR market models. The latter
class of models directly model observable market quantities, i.e., LIBOR
rates, and this feature makes these models relatively straightforward to
calibrate. Moreover, many securities of interest can easily be priced in
these models by making appropriate distributional assumptions about the
evolution of particular LIBOR rates.

In practice, short-rate models are often used as a complement and sanity

check for more sophisticated models. Moreover, their tractability means that
they will continue to be used for risk-management purposes.
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[4] Hull J. and A. White (1994) Numerical procedures for implementing term
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93