ORF555 / FIN555

:
Fixed Income Models
Damir Filipovi´c
Department of
Operations Research and Financial Engineering
Princeton University
Fall 2002
2
Contents
1 Introduction 7
2 Interest Rates and Related Contracts 9
2.1 Zero-Coupon Bonds . . . . . . . . . . . . . . . . . . . . . . . . 9
2.2 Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
2.2.1 Market Example: LIBOR . . . . . . . . . . . . . . . . 12
2.2.2 Simple vs. Continuous Compounding . . . . . . . . . . 12
2.2.3 Forward vs. Future Rates . . . . . . . . . . . . . . . . 13
2.3 Bank Account and Short Rates . . . . . . . . . . . . . . . . . 14
2.4 Coupon Bonds, Swaps and Yields . . . . . . . . . . . . . . . . 15
2.4.1 Fixed Coupon Bonds . . . . . . . . . . . . . . . . . . . 16
2.4.2 Floating Rate Notes . . . . . . . . . . . . . . . . . . . 16
2.4.3 Interest Rate Swaps . . . . . . . . . . . . . . . . . . . 17
2.4.4 Yield and Duration . . . . . . . . . . . . . . . . . . . . 20
2.5 Market Conventions . . . . . . . . . . . . . . . . . . . . . . . . 22
2.5.1 Day-count Conventions . . . . . . . . . . . . . . . . . . 22
2.5.2 Coupon Bonds . . . . . . . . . . . . . . . . . . . . . . 23
2.5.3 Accrued Interest, Clean Price and Dirty Price . . . . . 24
2.5.4 Yield-to-Maturity . . . . . . . . . . . . . . . . . . . . . 25
2.6 Caps and Floors . . . . . . . . . . . . . . . . . . . . . . . . . . 25
2.7 Swaptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
3 Statistics of the Yield Curve 33
3.1 Principal Component Analysis (PCA) . . . . . . . . . . . . . . 33
3.2 PCA of the Yield Curve . . . . . . . . . . . . . . . . . . . . . 35
3.3 Correlation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
3
4 CONTENTS
4 Estimating the Yield Curve 39
4.1 A Bootstrapping Example . . . . . . . . . . . . . . . . . . . . 39
4.2 General Case . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
4.2.1 Bond Markets . . . . . . . . . . . . . . . . . . . . . . . 45
4.2.2 Money Markets . . . . . . . . . . . . . . . . . . . . . . 46
4.2.3 Problems . . . . . . . . . . . . . . . . . . . . . . . . . 48
4.2.4 Parametrized Curve Families . . . . . . . . . . . . . . . 49
5 Why Yield Curve Models? 65
6 No-Arbitrage Pricing 67
6.1 Self-Financing Portfolios . . . . . . . . . . . . . . . . . . . . . 67
6.2 Arbitrage and Martingale Measures . . . . . . . . . . . . . . . 69
6.3 Hedging and Pricing . . . . . . . . . . . . . . . . . . . . . . . 73
7 Short Rate Models 77
7.1 Generalities . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
7.2 Diffusion Short Rate Models . . . . . . . . . . . . . . . . . . . 79
7.2.1 Examples . . . . . . . . . . . . . . . . . . . . . . . . . 82
7.3 Inverting the Yield Curve . . . . . . . . . . . . . . . . . . . . 83
7.4 Affine Term Structures . . . . . . . . . . . . . . . . . . . . . . 83
7.5 Some Standard Models . . . . . . . . . . . . . . . . . . . . . . 85
7.5.1 Vasicek Model . . . . . . . . . . . . . . . . . . . . . . . 85
7.5.2 Cox–Ingersoll–Ross Model . . . . . . . . . . . . . . . . 86
7.5.3 Dothan Model . . . . . . . . . . . . . . . . . . . . . . . 87
7.5.4 Ho–Lee Model . . . . . . . . . . . . . . . . . . . . . . . 88
7.5.5 Hull–White Model . . . . . . . . . . . . . . . . . . . . 89
7.6 Option Pricing in Affine Models . . . . . . . . . . . . . . . . . 90
7.6.1 Example: Vasicek Model (a, b, β const, α = 0). . . . . 92
8 HJM Methodology 95
9 Forward Measures 97
9.1 T-Bond as Numeraire . . . . . . . . . . . . . . . . . . . . . . . 97
9.2 An Expectation Hypothesis . . . . . . . . . . . . . . . . . . . 99
9.3 Option Pricing in Gaussian HJM Models . . . . . . . . . . . . 101
CONTENTS 5
10 Forwards and Futures 105
10.1 Forward Contracts . . . . . . . . . . . . . . . . . . . . . . . . 105
10.2 Futures Contracts . . . . . . . . . . . . . . . . . . . . . . . . . 106
10.3 Interest Rate Futures . . . . . . . . . . . . . . . . . . . . . . . 108
10.4 Forward vs. Futures in a Gaussian Setup . . . . . . . . . . . . 109
11 Multi-Factor Models 113
11.1 No-Arbitrage Condition . . . . . . . . . . . . . . . . . . . . . 115
11.2 Affine Term Structures . . . . . . . . . . . . . . . . . . . . . . 117
11.3 Polynomial Term Structures . . . . . . . . . . . . . . . . . . . 118
11.4 Exponential-Polynomial Families . . . . . . . . . . . . . . . . 122
11.4.1 Nelson–Siegel Family . . . . . . . . . . . . . . . . . . . 122
11.4.2 Svensson Family . . . . . . . . . . . . . . . . . . . . . 123
12 Market Models 127
12.1 Models of Forward LIBOR Rates . . . . . . . . . . . . . . . . 129
12.1.1 Discrete-tenor Case . . . . . . . . . . . . . . . . . . . . 130
12.1.2 Continuous-tenor Case . . . . . . . . . . . . . . . . . . 140
13 Default Risk 145
13.1 Transition and Default Probabilities . . . . . . . . . . . . . . . 145
13.1.1 Historical Method . . . . . . . . . . . . . . . . . . . . . 146
13.1.2 Structural Approach . . . . . . . . . . . . . . . . . . . 148
13.2 Intensity Based Method . . . . . . . . . . . . . . . . . . . . . 150
13.2.1 Construction of Intensity Based Models . . . . . . . . . 156
13.2.2 Computation of Default Probabilities . . . . . . . . . . 157
13.2.3 Pricing Default Risk . . . . . . . . . . . . . . . . . . . 157
13.2.4 Measure Change . . . . . . . . . . . . . . . . . . . . . 160
6 CONTENTS
Chapter 1
Introduction
These notes have been written for a graduate course on fixed income models
that I held in the fall term 2002–2003 at Princeton University.
The number of books on fixed income models is growing, yet it is difficult
to find a convenient textbook for a one-semester course like this. There are
several reasons for this:
• Until recently, many textbooks on mathematical finance have treated
stochastic interest rates as an appendix to the elementary arbitrage
pricing theory, which usually requires constant (zero) interest rates.
• Interest rate theory is not standardized yet: there is no well-accepted
“standard” general model such as the Black–Scholes model for equities.
• The very nature of fixed income instruments causes difficulties, other
than for stock derivatives, in implementing and calibrating models.
These issues should therefore not been left out.
I will frequently refer to the following books:
B[3]: Bj¨ ork (98) [3]. A pedagogically well written introduction to mathe-
matical finance. Chapters 15–20 are on interest rates.
BM[6]: Brigo–Mercurio (01) [6]. This is a book on interest rate modelling
written by two quantitative analysts in financial institutions. Much
emphasis is on the practical implementation and calibration of selected
models.
7
8 CHAPTER 1. INTRODUCTION
JW[11]: James–Webber (00) [11]. An encyclopedic treatment of interest
rates and their related financial derivatives.
J[13]: Jarrow (96) [13]. Introduction to fixed-income securities and interest
rate options. Discrete time only.
MR[19]: Musiela–Rutkowski (97) [19]. A comprehensive book on financial
mathematics with a large part (Part II) on interest rate modelling.
Much emphasis is on market pricing practice.
R[22]: Rebonato (98) [22]. Written by a practitionar. Much emphasis on
market practice for pricing and handling interest rate derivatives.
Z[27]: Zagst (02) [27]. A comprehensive textbook on mathematical finance,
interest rate modelling and risk management.
I did not intend to write an entire text but rather collect fragments of the
material that can be found in the above books and further references.
Chapter 2
Interest Rates and Related
Contracts
Literature: B[3](Chapter 15), BM[6](Chapter 1), and many more
2.1 Zero-Coupon Bonds
A dollar today is worth more than a dollar tomorrow. The time t value of
a dollar at time T ≥ t is expressed by the zero-coupon bond with maturity
T, P(t, T), for briefty also T-bond. This is a contract which guarantees the
holder one dollar to be paid at the maturity date T.
1 P(t,T)
t
| |
T
→ future cashflows can be discounted, such as coupon-bearing bonds
C
1
P(t, t
1
) + +C
n−1
P(t, t
n−1
) + (1 +C
n
)P(t, T).
In theory we will assume that
• there exists a frictionless market for T-bonds for every T > 0.
• P(T, T) = 1 for all T.
• P(t, T) is continuously differentiable in T.
9
10 CHAPTER 2. INTEREST RATES AND RELATED CONTRACTS
In reality this assumptions are not always satisfied: zero-coupon bonds are
not traded for all maturities, and P(T, T) might be less than one if the issuer
of the T-bond defaults. Yet, this is a good starting point for doing the
mathematics. More realistic models will be introduced and discussed in the
sequel.
The third condition is purely technical and implies that the term structure
of zero-coupon bond prices T → P(t, T) is a smooth curve.
1 2 3 4 5 6 7 8 9 10
Years
0.2
0.4
0.6
0.8
1
US Treasury Bonds, March 2002
Note that t → P(t, T) is a stochastic process since bond prices P(t, T) are
not known with certainty before t.
1 2 3 4 5 6 7 8 9 10
t
0.2
0.4
0.6
0.8
1
PHt,10L
A reasonable assumption would also be that T → P(t, T) ≤ 1 is a de-
creasing curve (which is equivalent to positivity of interest rates). However,
already classical interest rate models imply zero-coupon bond prices greater
than 1. Therefore we leave away this requirement.
2.2. INTEREST RATES 11
2.2 Interest Rates
The term structure of zero-coupon bond prices does not contain much visual
information (strictly speaking it does). A better measure is given by the
implied interest rates. There is a variety of them.
A prototypical forward rate agreement (FRA) is a contract involving three
time instants t < T < S: the current time t, the expiry time T > t, and the
maturity time S > T.
• At t: sell one T-bond and buy
P(t,T)
P(t,S)
S-bonds = zero net investment.
• At T: pay one dollar.
• At S: obtain
P(t,T)
P(t,S)
dollars.
The net effect is a forward investment of one dollar at time T yielding
P(t,T)
P(t,S)
dollars at S with certainty.
We are led to the following definitions.
• The simple (simply-compounded) forward rate for [T, S] prevailing at t
is given by
1+(S−T)F(t; T, S) :=
P(t, T)
P(t, S)
⇔F(t; T, S) =
1
S −T

P(t, T)
P(t, S)
−1

.
• The simple spot rate for [t, T] is
F(t, T) := F(t; t, T) =
1
T −t

1
P(t, T)
−1

.
• The continuously compounded forward rate for [T, S] prevailing at t is
given by
e
R(t;T,S)(S−T)
:=
P(t, T)
P(t, S)
⇔R(t; T, S) = −
log P(t, S) −log P(t, T)
S −T
.
• The continuously compounded spot rate for [T, S] is
R(t, T) := R(t; t, T) = −
log P(t, T)
T −t
.
12 CHAPTER 2. INTEREST RATES AND RELATED CONTRACTS
• The instantaneous forward rate with maturity T prevailing at time t is
defined by
f(t, T) := lim
S↓T
R(t; T, S) = −
∂ log P(t, T)
∂T
. (2.1)
The function T →f(t, T) is called the forward curve at time t.
• The instantaneous short rate at time t is defined by
r(t) := f(t, t) = lim
T↓t
R(t, T).
Notice that (2.1) together with the requirement P(T, T) = 1 is equivalent to
P(t, T) = exp

T
t
f(t, u) du

.
2.2.1 Market Example: LIBOR
“Interbank rates” are rates at which deposits between banks are exchanged,
and at which swap transactions (see below) between banks occur. The most
important interbank rate usually considered as a reference for fixed income
contracts is the LIBOR (London InterBank Offered Rate)
1
for a series of
possible maturities, ranging from overnight to 12 months. These rates are
quoted on a simple compounding basis. For example, the three-months for-
ward LIBOR for the period [T, T + 1/4] at time t is given by
L(t, T) = F(t; T, T + 1/4).
2.2.2 Simple vs. Continuous Compounding
One dollar invested for one year at an interest rate of R per annum growths
to 1 + R. If the rate is compounded twice per year the terminal value is
(1 +R/2)
2
, etc. It is a mathematical fact that

1 +
R
m

m
→e
R
as m → ∞.
1
To be more precise: this is the rate at which high-credit financial institutions can
borrow in the interbank market.
2.2. INTEREST RATES 13
Moreover,
e
R
= 1 +R +o(R) for R small.
Example: e
0.04
= 1.04081.
Since the exponential function has nicer analytic properties than power
functions, we often consider continuously compounded interest rates. This
makes the theory more tractable.
2.2.3 Forward vs. Future Rates
Can forward rates predict the future spot rates?
Consider a deterministic world. If markets are efficient (i.e. no arbitrage
= no riskless, systematic profit) we have necessarily
P(t, S) = P(t, T)P(T, S), ∀t ≤ T ≤ S. (2.2)
Proof. Suppose that P(t, S) > P(t, T)P(T, S) for some t ≤ T ≤ S. Then we
follow the strategy:
• At t: sell one S-bond, and buy P(T, S) T-bonds.
Net cost: −P(t, S) +P(t, T)P(T, S) < 0.
• At T: receive P(T, S) dollars and buy one S-bond.
• At S: pay one dollar, receive one dollar.
(Where do we use the assumption of a deterministic world?)
The net is a riskless gain of −P(t, S)+P(t, T)P(T, S) (1/P(t, S)). This
is a pure arbitrage opportunity, which contradicts the assumption.
If P(t, S) < P(t, T)P(T, S) the same profit can be realized by changing
sign in the strategy.
Taking logarithm in (2.2) yields

S
T
f(t, u) du =

S
T
f(T, u) du, ∀t ≤ T ≤ S.
This is equivalent to
f(t, S) = f(T, S) = r(S), ∀t ≤ T ≤ S
14 CHAPTER 2. INTEREST RATES AND RELATED CONTRACTS
(as time goes by we walk along the forward curve: the forward curve is
shifted). In this case, the forward rate with maturity S prevailing at time
t ≤ S is exactly the future short rate at S.
The real world is not deterministic though. We will see that in general
the forward rate f(t, T) is the conditional expectation of the short rate r(T)
under a particular probability measure (forward measure), depending on T.
Hence the forward rate is a biased estimator for the future short rate.
Forecasts of future short rates by forward rates have little or no predictive
power.
2.3 Bank Account and Short Rates
The return of a one dollar investment today (t = 0) over the period [0, ∆t]
is given by
1
P(0, ∆t)
= exp

∆t
0
f(0, u) du

= 1 +r(0)∆t +o(∆t).
Instantaneous reinvestment in 2∆t-bonds yields
1
P(0, ∆t)
1
P(∆t, 2∆t)
= (1 +r(0)∆t)(1 +r(∆t)∆t) +o(∆t)
at time 2∆t, etc. This strategy of “rolling over”
2
just maturing bonds leads
in the limit to the bank account (money-market account) B(t). Hence B(t)
is the asset which growths at time t instantaneously at short rate r(t)
B(t + ∆t) = B(t)(1 +r(t)∆t) +o(∆t).
For ∆t →0 this converges to
dB(t) = r(t)B(t)dt
and with B(0) = 1 we obtain
B(t) = exp

t
0
r(s) ds

.
2
This limiting process is made rigorous in [4].
2.4. COUPON BONDS, SWAPS AND YIELDS 15
B is a risk-free asset insofar as its future value at time t + ∆t is known (up
to order ∆t) at time t. In stochastic terms we speak of a predictable process.
For the same reason we speak of r(t) as the risk-free rate of return over the
infinitesimal period [t, t +dt].
B is important for relating amounts of currencies available at different
times: in order to have one dollar in the bank account at time T we need to
have
B(t)
B(T)
= exp

T
t
r(s) ds

dollars in the bank account at time t ≤ T. This discount factor is stochastic:
it is not known with certainty at time t. There is a close connection to the
deterministic (=known at time t) discount factor given by P(t, T). Indeed,
we will see that the latter is the conditional expectation of the former under
the risk neutral probability measure.
Proxies for the Short Rate
→ JW[11](Chapter 3.5)
The short rate r(t) is a key interest rate in all models and fundamental
to no-arbitrage pricing. But it cannot be directly observed.
The overnight interest rate is not usually considered to be a good proxy
for the short rate, because the motives and needs driving overnight borrowers
are very different from those of borrowers who want money for a month or
more.
The overnight fed funds rate is nevertheless comparatively stable and
perhaps a fair proxy, but empirical studies suggest that it has low correlation
with other spot rates.
The best available proxy is given by one- or three-month spot rates since
they are very liquid.
2.4 Coupon Bonds, Swaps and Yields
In most bond markets, there is only a relatively small number of zero-coupon
bonds traded. Most bonds include coupons.
16 CHAPTER 2. INTEREST RATES AND RELATED CONTRACTS
2.4.1 Fixed Coupon Bonds
A fixed coupon bond is a contract specified by
• a number of future dates T
1
< < T
n
(the coupon dates)
(T
n
is the maturity of the bond),
• a sequence of (deterministic) coupons c
1
, . . . , c
n
,
• a nominal value N,
such that the owner receives c
i
at time T
i
, for i = 1, . . . , n, and N at terminal
time T
n
. The price p(t) at time t ≤ T
1
of this coupon bond is given by the
sum of discounted cashflows
p(t) =
n
¸
i=1
P(t, T
i
)c
i
+P(t, T
n
)N.
Typically, it holds that T
i+1
−T
i
≡ δ, and the coupons are given as a fixed
percentage of the nominal value: c
i
≡ KδN, for some fixed interest rate K.
The above formula reduces to
p(t) =


n
¸
i=1
P(t, T
i
) +P(t, T
n
)

N.
2.4.2 Floating Rate Notes
There are versions of coupon bonds for which the value of the coupon is
not fixed at the time the bond is issued, but rather reset for every coupon
period. Most often the resetting is determined by some market interest rate
(e.g. LIBOR).
A floating rate note is specified by
• a number of future dates T
0
< T
1
< < T
n
,
• a nominal value N.
The deterministic coupon payments for the fixed coupon bond are now re-
placed by
c
i
= (T
i
−T
i−1
)F(T
i−1
, T
i
)N,
2.4. COUPON BONDS, SWAPS AND YIELDS 17
where F(T
i−1
, T
i
) is the prevailing simple market interest rate, and we note
that F(T
i−1
, T
i
) is determined already at time T
i−1
(this is why here we have
T
0
in addition to the coupon dates T
1
, . . . , T
n
), but that the cash-flow c
i
is
at time T
i
.
The value p(t) of this note at time t ≤ T
0
is obtained as follows. Without
loss of generality we set N = 1. By definition of F(T
i−1
, T
i
) we then have
c
i
=
1
P(T
i−1
, T
i
)
−1.
The time t value of −1 paid out at T
i
is −P(t, T
i
). The time t value of
1
P(T
i−1
,T
i
)
paid out at T
i
is P(t, T
i−1
):
• At t: buy a T
i−1
-bond. Cost: P(t, T
i−1
).
• At T
i−1
: receive one dollar and buy 1/P(T
i−1
, T
i
) T
i
-bonds. Zero net
investment.
• At T
i
: receive 1/P(T
i−1
, T
i
) dollars.
The time t value of c
i
therefore is
P(t, T
i−1
) −P(t, T
i
).
Summing up we obtain the (surprisingly easy) formula
p(t) = P(t, T
n
) +
n
¸
i=1
(P(t, T
i−1
) −P(t, T
i
)) = P(t, T
0
).
In particular, for t = T
0
: p(T
0
) = 1.
2.4.3 Interest Rate Swaps
An interest rate swap is a scheme where you exchange a payment stream
at a fixed rate of interest for a payment stream at a floating rate (typically
LIBOR).
There are many versions of interest rate swaps. A payer interest rate
swap settled in arrears is specified by
• a number of future dates T
0
< T
1
< < T
n
with T
i
−T
i−1
≡ δ
(T
n
is the maturity of the swap),
18 CHAPTER 2. INTEREST RATES AND RELATED CONTRACTS
• a fixed rate K,
• a nominal value N.
Of course, the equidistance hypothesis is only for convenience of notation
and can easily be relaxed. Cashflows take place only at the coupon dates
T
1
, . . . , T
n
. At T
i
, the holder of the contract
• pays fixed KδN,
• and receives floating F(T
i−1
, T
i
)δN.
The net cashflow at T
i
is thus
(F(T
i−1
, T
i
) −K)δN,
and using the previous results we can compute the value at t ≤ T
0
of this
cashflow as
N(P(t, T
i−1
) −P(t, T
i
) −KδP(t, T
i
)). (2.3)
The total value Π
p
(t) of the swap at time t ≤ T
0
is thus
Π
p
(t) = N

P(t, T
0
) −P(t, T
n
) −Kδ
n
¸
i=1
P(t, T
i
)

.
A receiver interest rate swap settled in arrears is obtained by changing
the sign of the cashflows at times T
1
, . . . , T
n
. Its value at time t ≤ T
0
is thus
Π
r
(t) = −Π
p
(t).
The remaining question is how the “fair” fixed rate K is determined. The
forward swap rate R
swap
(t) at time t ≤ T
0
is the fixed rate K above which
gives Π
p
(t) = Π
r
(t) = 0. Hence
R
swap
(t) =
P(t, T
0
) −P(t, T
n
)
δ
¸
n
i=1
P(t, T
i
)
.
The following alternative representation of R
swap
(t) is sometimes useful.
Since P(t, T
i−1
) −P(t, T
i
) = F(t; T
i−1
, T
i
)δP(t, T
i
), we can rewrite (2.3) as
NδP(t, T
i
) (F(t; T
i−1
, T
i
) −K) .
2.4. COUPON BONDS, SWAPS AND YIELDS 19
Summing up yields
Π
p
(t) = Nδ
n
¸
i=1
P(t, T
i
) (F(t; T
i−1
, T
i
) −K) ,
and thus we can write the swap rate as weighted average of simple forward
rates
R
swap
(t) =
n
¸
i=1
w
i
(t)F(t; T
i−1
, T
i
),
with weights
w
i
(t) =
P(t, T
i
)
¸
n
j=1
P(t, T
j
)
.
These weights are random, but there seems to be empirical evidence that
the variability of w
i
(t) is small compared to that of F(t; T
i−1
, T
i
). This is
used for approximations of swaption (see below) price formulas in LIBOR
market models: the swap rate volatility is written as linear combination of
the forward LIBOR volatilities (“Rebonato’s formula” → BM[6], p.248).
Swaps were developed because different companies could borrow at dif-
ferent rates in different markets.
Example
→ JW[11](p.11)
• Company A: is borrowing fixed for five years at 5 1/2%, but could
borrow floating at LIBOR plus 1/2%.
• Company B: is borrowing floating at LIBOR plus 1%, but could borrow
fixed for five years at 6 1/2%.
By agreeing to swap streams of cashflows both companies could be better
off, and a mediating institution would also make money.
• Company A pays LIBOR to the intermediary in exchange for fixed at
5 3/16% (receiver swap).
• Company B pays the intermediary fixed at 5 5/16% in exchange for
LIBOR (payer swap).
20 CHAPTER 2. INTEREST RATES AND RELATED CONTRACTS
Net:
• Company A is now paying LIBOR plus 5/16% instead of LIBOR plus
1/2%.
• Company B is paying fixed at 6 5/16% instead of 6 1/2%.
• The intermediary receives fixed at 1/8%.
5 5/16 % 5 3/16 %
LIBOR LIBOR LIBOR + 1%
5 1/2 %
Company A Intermediary Company B
Everyone seems to be better off. But there is implicit credit risk; this is
why Company B had higher borrowing rates in the first place. This risk has
been partly taken up by the intermediary, in return for the money it makes
on the spread.
2.4.4 Yield and Duration
For a zero-coupon bond P(t, T) the zero-coupon yield is simply the continu-
ously compounded spot rate R(t, T). That is,
P(t, T) = e
−R(t,T)(T−t)
.
Accordingly, the function T → R(t, T) is referred to as (zero-coupon) yield
curve.
The term “yield curve” is ambiguous. There is a variety of other ter-
minologies, such as zero-rate curve (Z[27]), zero-coupon curve (BM[6]). In
JW[11] the yield curve is is given by simple spot rates, and in BM[6] it is a
combination of simple spot rates (for maturities up to 1 year) and annually
compounded spot rates (for maturities greater than 1 year), etc.
2.4. COUPON BONDS, SWAPS AND YIELDS 21
1 2 3 4 5 6 7 8 9 10
Years
0.02
0.04
0.06
0.08
0.1
US Yield Curve, March 2002
Now let p(t) be the time t market value of a fixed coupon bond with
coupon dates T
1
< < T
n
, coupon payments c
1
, . . . , c
n
and nominal value
N (see Section 2.4.1). For simplicity we suppose that c
n
already contains N,
that is,
p(t) =
n
¸
i=1
P(t, T
i
)c
i
, t ≤ T
1
.
Again we ask for the bond’s “internal rate of interest”; that is, the constant
(over the period [t, T
n
]) continuously compounded rate which generates the
market value of the coupon bond: the (continuously compounded) yield-to-
maturity y(t) of this bond at time t ≤ T
1
is defined as the unique solution
to
p(t) =
n
¸
i=1
c
i
e
−y(t)(T
i
−t)
.
Remark 2.4.1. → R[22](p.21). It is argued by Schaefer (1977) that the
yield-to-maturity is an inadequate statistics for the bond market:
• coupon payments occurring at the same point in time are discounted by
different discount factors, but
• coupon payments at different points in time from the same bond are
discounted by the same rate.
To simplify the notation we assume now that t = 0, and write p = p(0),
y = y(0), etc. The Macaulay duration of the coupon bond is defined as
D
Mac
:=
¸
n
i=1
T
i
c
i
e
−yT
i
p
.
22 CHAPTER 2. INTEREST RATES AND RELATED CONTRACTS
The duration is thus a weighted average of the coupon dates T
1
, . . . , T
n
, and
it provides us in a certain sense with the “mean time to coupon payment”.
As such it is an important concept for interest rate risk management: it acts
as a measure of the first order sensitivity of the bond price w.r.t. changes in
the yield-to-maturity (see Z[27](Chapter 6.1.3) for a thourough treatment).
This is shown by the obvious formula
dp
dy
=
d
dy

n
¸
i=1
c
i
e
−yT
i

= −D
Mac
p.
A first order sensitivity measure of the bond price w.r.t. parallel shifts of
the entire zero-coupon yield curve T → R(0, T) is given by the duration of
the bond
D :=
¸
n
i=1
T
i
c
i
e
−y
i
T
i
p
=
n
¸
i=1
c
i
P(0, T
i
)
p
T
i
,
with y
i
:= R(0, T
i
). In fact, we have
d
ds

n
¸
i=1
c
i
e
−(y
i
+s)T
i

[
s=0
= −Dp.
Hence duration is essentially for bonds (w.r.t. parallel shift of the yield curve)
what delta is for stock options. The bond equivalent of the gamma is con-
vexity:
C :=
d
2
ds
2

n
¸
i=1
c
i
e
−(y
i
+s)T
i

[
s=0
=
n
¸
i=1
c
i
e
−y
i
T
i
(T
i
)
2
.
2.5 Market Conventions
2.5.1 Day-count Conventions
Time is measured in years.
If t and T denote two dates expressed as day/month/year, it is not clear
what T −t should be. The market evaluates the year fraction between t and
T in different ways.
The day-count convention decides upon the time measurement between
two dates t and T.
Here are three examples of day-count conventions:
2.5. MARKET CONVENTIONS 23
• Actual/365: a year has 365 days, and the day-count convention for
T −t is given by
actual number of days between t and T
365
.
• Actual/360: as above but the year counts 360 days.
• 30/360: months count 30 and years 360 days. Let t = (d
1
, m
1
, y
1
) and
T = (d
2
, m
2
, y
2
). The day-count convention for T −t is given by
min(d
2
, 30) + (30 −d
1
)
+
360
+
(m
2
−m
1
−1)
+
12
+y
2
−y
1
.
Example: The time between t=January 4, 2000 and T=July 4, 2002 is
given by
4 + (30 −4)
360
+
7 −1 −1
12
+ 2002 −2000 = 2.5.
When extracting information on interest rates from data, it is important
to realize for which day-count convention a specific interest rate is quoted.
→ BM[6](p.4), Z[27](Sect. 5.1)
2.5.2 Coupon Bonds
→ MR[19](Sect. 11.2), Z[27](Sect. 5.2), J[13](Chapter 2)
Coupon bonds issued in the American (European) markets typically have
semi-annual (annual) coupon payments.
Debt securities issued by the U.S. Treasury are divided into three classes:
• Bills: zero-coupon bonds with time to maturity less than one year.
• Notes: coupon bonds (semi-annual) with time to maturity between 2
and 10 years.
• Bonds: coupon bonds (semi-annual) with time to maturity between 10
and 30 years
3
.
3
Recently, the issuance of 30 year treasury bonds has been stopped.
24 CHAPTER 2. INTEREST RATES AND RELATED CONTRACTS
In addition to bills, notes and bonds, Treasury securities called STRIPS
(separate trading of registered interest and principal of securities) have traded
since August 1985. These are the coupons or principal (=nominal) amounts
of Treasury bonds trading separately through the Federal Reserve’s book-
entry system. They are synthetically created zero-coupon bonds of longer
maturities than a year. They were created in response to investor demands.
2.5.3 Accrued Interest, Clean Price and Dirty Price
Remember that we had for the price of a coupon bond with coupon dates
T
1
, . . . , T
n
and payments c
1
, . . . , c
n
the price formula
p(t) =
n
¸
i=1
c
i
P(t, T
i
), t ≤ T
1
.
For t ∈ (T
1
, T
2
] we have
p(t) =
n
¸
i=2
c
i
P(t, T
i
),
etc. Hence there are systematic discontinuities of the price trajectory at
t = T
1
, . . . , T
n
which is due to the coupon payments. This is why prices are
differently quoted at the exchange.
The accrued interest at time t ∈ (T
i−1
, T
i
] is defined by
AI(i; t) := c
i
t −T
i−1
T
i
−T
i−1
(where now time differences are taken according to the day-count conven-
tion). The quoted price, or clean price, of the coupon bond at time t is
p
clean
(t) := p(t) −AI(i; t), t ∈ (T
i−1
, T
i
].
That is, whenever we buy a coupon bond quoted at a clean price of p
clean
(t)
at time t ∈ (T
i−1
, T
i
], the cash price, or dirty price, we have to pay is
p(t) = p
clean
(t) +AI(i; t).
2.6. CAPS AND FLOORS 25
2.5.4 Yield-to-Maturity
The quoted (annual) yield-to-maturity ˆ y(t) on a Treasury bond at time t = T
i
is defined by the relationship
p
clean
(T
i
) =
n
¸
j=i+1
r
c
N/2
(1 + ˆ y(T
i
)/2)
j−i
+
N
(1 + ˆ y(T
i
)/2)
n−i
,
and at t ∈ [T
i
, T
i+1
)
p
clean
(t) =
n
¸
j=i+1
r
c
N/2
(1 + ˆ y(t)/2)
j−i−1+τ
+
N
(1 + ˆ y(t)/2)
n−i−1+τ
,
where r
c
is the (annualized) coupon rate, N the nominal amount and
τ =
T
i+1
−t
T
i+1
−T
i
is again given by the day-count convention, and we assume here that
T
i+1
−T
i
≡ 1/2 (semi-annual coupons).
2.6 Caps and Floors
→ BM[6](Sect. 1.6), Z[27](Sect. 5.6.2)
Caps
A caplet with reset date T and settlement date T + δ pays the holder the
difference between a simple market rate F(T, T + δ) (e.g. LIBOR) and the
strike rate κ. Its cashflow at time T +δ is
δ(F(T, T +δ) −κ)
+
.
A cap is a strip of caplets. It thus consists of
• a number of future dates T
0
< T
1
< < T
n
with T
i
−T
i−1
≡ δ
(T
n
is the maturity of the cap),
• a cap rate κ.
26 CHAPTER 2. INTEREST RATES AND RELATED CONTRACTS
Cashflows take place at the dates T
1
, . . . , T
n
. At T
i
the holder of the cap
receives
δ(F(T
i−1
, T
i
) −κ)
+
. (2.4)
Let t ≤ T
0
. We write
Cpl(i; t), i = 1, . . . , n,
for the time t price of the ith caplet with reset date T
i−1
and settlement date
T
i
, and
Cp(t) =
n
¸
i=1
Cpl(i; t)
for the time t price of the cap.
A cap gives the holder a protection against rising interest rates. It guar-
antees that the interest to be paid on a floating rate loan never exceeds the
predetermined cap rate κ.
It can be shown (→ exercise) that the cashflow (2.4) at time T
i
is the
equivalent to (1 + δκ) times the cashflow at date T
i−1
of a put option on a
T
i
-bond with strike price 1/(1 +δκ) and maturity T
i−1
, that is,
(1 +δκ)

1
1 +δκ
−P(T
i−1
, T
i
)

+
.
This is an important fact because many interest rate models have explicit
formulae for bond option values, which means that caps can be priced very
easily in those models.
Floors
A floor is the converse to a cap. It protects against low rates. A floor is a
strip of floorlets, the cashflow of which is – with the same notation as above
– at time T
i
δ(κ −F(T
i−1
, T
i
))
+
.
Write Fll(i; t) for the price of the ith floorlet and
Fl(t) =
n
¸
i=1
Fll(i; t)
for the price of the floor.
2.6. CAPS AND FLOORS 27
Caps, Floors and Swaps
Caps and floors are strongly related to swaps. Indeed, one can show the
parity relation (→ exercise)
Cp(t) −Fl(t) = Π
p
(t),
where Π
p
(t) is the value at t of a payer swap with rate κ, nominal one and
the same tenor structure as the cap and floor.
Let t = 0. The cap/floor is said to be at-the-money (ATM) if
κ = R
swap
(0) =
P(0, T
0
) −P(0, T
n
)
δ
¸
n
i=1
P(0, T
i
)
,
the forward swap rate. The cap (floor) is in-the-money (ITM) if κ < R
swap
(0)
(κ > R
swap
(0)), and out-of-the-money (OTM) if κ > R
swap
(0) (κ < R
swap
(0)).
Black’s Formula
It is market practice to price a cap/floor according to Black’s formula. Let
t ≤ T
0
. Black’s formula for the value of the ith caplet is
Cpl(i; t) = δP(t, T
i
) (F(t; T
i−1
, T
i
)Φ(d
1
(i; t)) −κΦ(d
2
(i; t))) ,
where
d
1,2
(i; t) :=
log

F(t;T
i−1
,T
i
)
κ

±
1
2
σ(t)
2
(T
i−1
−t)
σ(t)

T
i−1
−t
(Φ stands for the standard Gaussian cumulative distribution function), and
σ(t) is the cap volatility (it is the same for all caplets).
Correspondingly, Black’s formula for the value of the ith floorlet is
Fll(i; t) = δP(t, T
i
) (κΦ(−d
2
(i; t)) −F(t; T
i−1
, T
i
)Φ(−d
1
(i; t))) .
Cap/floor prices are quoted in the market in term of their implied volatil-
ities. Typically, we have t = 0, and T
0
and δ = T
i
−T
i−1
being equal to three
months.
An example of a US dollar ATM market cap volatility curve is shown in
Table 2.1 and Figure 2.1 (→ JW[11](p.49)).
It is a challenge for any market realistic interest rate model to match the
given volatility curve.
28 CHAPTER 2. INTEREST RATES AND RELATED CONTRACTS
Table 2.1: US dollar ATM cap volatilities, 23 July 1999
Maturity ATM vols
(in years) (in %)
1 14.1
2 17.4
3 18.5
4 18.8
5 18.9
6 18.7
7 18.4
8 18.2
10 17.7
12 17.0
15 16.5
20 14.7
30 12.4
Figure 2.1: US dollar ATM cap volatilities, 23 July 1999
5 10 15 20 25 30
12%
14%
16%
18%
2.7. SWAPTIONS 29
2.7 Swaptions
A European payer (receiver) swaption with strike rate K is an option giving
the right to enter a payer (receiver) swap with fixed rate K at a given future
date, the swaption maturity. Usually, the swaption maturity coincides with
the first reset date of the underlying swap. The underlying swap lenght
T
n
−T
0
is called the tenor of the swaption.
Recall that the value of a payer swap with fixed rate K at its first reset
date, T
0
, is
Π
p
(T
0
, K) = N
n
¸
i=1
P(T
0
, T
i
)δ(F(T
0
; T
i−1
, T
i
) −K).
Hence the payoff of the swaption with strike rate K at maturity T
0
is
N

n
¸
i=1
P(T
0
, T
i
)δ(F(T
0
; T
i−1
, T
i
) −K)

+
. (2.5)
Notice that, contrary to the cap case, this payoff cannot be decomposed
into more elementary payoffs. This is a fundamental difference between
caps/floors and swaptions. Here the correlation between different forward
rates will enter the valuation procedure.
Since Π
p
(T
0
, R
swap
(T
0
)) = 0, one can show (→ exercise) that the payoff
(2.5) of the payer swaption at time T
0
can also be written as
Nδ(R
swap
(T
0
) −K)
+
n
¸
i=1
P(T
0
, T
i
),
and for the receiver swaption
Nδ(K −R
swap
(T
0
))
+
n
¸
i=1
P(T
0
, T
i
).
Accordingly, at time t ≤ T
0
, the payer (receiver) swaption with strike rate
K is said to be ATM, ITM, OTM, if
K = R
swap
(t), K < (>)R
swap
(t), K > (<)R
swap
(t),
respectively.
30 CHAPTER 2. INTEREST RATES AND RELATED CONTRACTS
Black’s Formula
Black’s formula for the price at time t ≤ T
0
of the payer (Swpt
p
(t)) and
receiver (Swpt
r
(t)) swaption is
Swpt
p
(t) = Nδ (R
swap
(t)Φ(d
1
(t)) −KΦ(d
2
(t)))
n
¸
i=1
P(t, T
i
),
Swpt
r
(t) = Nδ (KΦ(−d
2
(t)) −R
swap
(t)Φ(−d
1
(t)))
n
¸
i=1
P(t, T
i
),
with
d
1,2
(t) :=
log

Rswap(t)
K

±
1
2
σ(t)
2
(T
0
−t)
σ(t)

T
0
−t
,
and σ(t) is the prevailing Black’s swaption volatility.
Swaption prices are quoted in terms of implied volatilities in matrix form.
An x y-swaption is the swaption with maturity in x years and whose un-
derlying swap is y years long.
A typical example of implied swaption volatilities is shown in Table 2.2
and Figure 2.2 (→ BM[6](p.253)).
An interest model for swaptions valuation must fit the given today’s
volatility surface.
2.7. SWAPTIONS 31
Table 2.2: Black’s implied volatilities (in %) of ATM swaptions on May 16,
2000. Maturities are 1,2,3,4,5,7,10 years, swaps lengths from 1 to 10 years.
1y 2y 3y 4y 5y 6y 7y 8y 9y 10y
1y 16.4 15.8 14.6 13.8 13.3 12.9 12.6 12.3 12.0 11.7
2y 17.7 15.6 14.1 13.1 12.7 12.4 12.2 11.9 11.7 11.4
3y 17.6 15.5 13.9 12.7 12.3 12.1 11.9 11.7 11.5 11.3
4y 16.9 14.6 12.9 11.9 11.6 11.4 11.3 11.1 11.0 10.8
5y 15.8 13.9 12.4 11.5 11.1 10.9 10.8 10.7 10.5 10.4
7y 14.5 12.9 11.6 10.8 10.4 10.3 10.1 9.9 9.8 9.6
10y 13.5 11.5 10.4 9.8 9.4 9.3 9.1 8.8 8.6 8.4
Figure 2.2: Black’s implied volatilities (in %) of ATM swaptions on May 16,
2000.
2
4
6
8
10
Maturity
2
4
6
8
10
Tenor
10
12
14
16
Vol
10
12
14
16
Vol
32 CHAPTER 2. INTEREST RATES AND RELATED CONTRACTS
Chapter 3
Some Statistics of the Yield
Curve
3.1 Principal Component Analysis (PCA)
→ JW[11](Chapter 16.2), [21]
• Let x(1), . . . , x(N) be a sample of a random n 1 vector x.
• Form the empirical n n covariance matrix
ˆ
Σ,
ˆ
Σ
ij
=
¸
N
k=1
(x
i
(k) −µ[x
i
])(x
j
(k) −µ[x
j
])
N −1
=
¸
N
k=1
x
i
(k)x
i
(k) −Nµ[x
i
]µ[x
j
]
N −1
,
where
µ[x
i
] :=
1
N
N
¸
k=1
x
i
(k) (mean of x
i
).
We assume that
ˆ
Σ is non-degenerate (otherwise we can express an x
i
as linear combination of the other x
j
s).
• There exists a unique orthogonal matrix A = (p
1
, . . . , p
n
) (that is,
A
−1
= A
T
and A
ij
= p
j;i
) consisting of orthonormal n1 Eigenvectors
p
i
of
ˆ
Σ such that
ˆ
Σ = ALA
T
,
33
34 CHAPTER 3. STATISTICS OF THE YIELD CURVE
where L = diag(λ
1
, . . . , λ
n
) with λ
1
≥ ≥ λ
n
> 0 (the Eigenvalues
of
ˆ
Σ).
• Define z := A
T
x. Then
Cov[z
i
, z
j
] =
n
¸
k,l=1
A
T
ik
Cov[x
k
, x
l
]A
T
jl
=

A
T
ˆ
ΣA

ij
= λ
i
δ
ij
.
Hence the z
i
s are uncorrelated.
• The principal components (PCs) are the n 1 vectors p
1
, . . . , p
n
:
x = Az = z
1
p
1
+ z
n
p
n
.
The importance of component p
i
is determined by the size of the cor-
responding Eigenvalue, λ
i
, which indicates the amount of variance ex-
plained by p
i
. The key statistics is the proportion
λ
i
¸
n
j=1
λ
j
,
the explained variance by p
i
.
• Normalization: let ˜ w := (L
1/2
)
−1
z, where L
1/2
:= diag(

λ
1
, . . . ,

λ
n
),
and w = ˜ w −µ[ ˜ w] (µ[ ˜ w]=mean of ˜ w). Then
µ[w] = 0, Cov[w
i
, w
j
] = Cov[ ˜ w
i
, ˜ w
j
] = δ
ij
,
and
x = µ[x] +AL
1/2
w = µ[x] +
n
¸
j=1
p
j

λ
j
w
j
.
In components
x
i
= µ[x
i
] +
n
¸
j=1
A
ij

λ
j
w
j
.
• Sometimes the following view is useful (→ R[22](Chapter 3)): set
σ
i
:= V ar[x
i
]
1/2
=

ˆ
Σ
ii

1/2
=

n
¸
j=1
A
2
ij
λ
j

1/2
v
i
:=
x
i
−µ[x
i
]
σ
i
=
¸
n
j=1
A
ij

λ
j
w
j
σ
i
, i = 1, . . . , n.
3.2. PCA OF THE YIELD CURVE 35
Then we have µ[v
i
] = 0, µ[v
2
i
] = 1 and
x
i
= µ[x
i
] +σ
i
v
i
.
It can be appropriate to assume a parametric functional form (→ re-
duction of parameters) of the correlation structure of x,
Corr[x
i
, x
j
] = Cov[v
i
, v
j
] =
ˆ
Σ
ij
σ
i
σ
j
=
¸
n
k=1
A
ik
A
jk
λ
k
σ
i
σ
j
= ρ(π; i, j),
where π is some low-dimensional parameter (this is adapted to the
calibration of market models → BM[6](Chapter 6.9)).
3.2 PCA of the Yield Curve
Now let x = (x
1
, . . . , x
n
)
T
be the increments of the forward curve, say
x
i
= R(t + ∆t; t + ∆t +τ
i−1
, t + ∆t +τ
i
) −R(t; t +τ
i−1
, t +τ
i
),
for some maturity spectrum 0 = τ
0
< < τ
n
.
PCA typically leads to the following picture (→ R[22]p.61): UK market
in the years 1989-1992 (the original maturity spectrum has been divided into
eight distinct buckets, i.e. n = 8).
The first three principal components are
p
1
=

¸
¸
¸
¸
¸
¸
¸
¸
¸
¸
¸
0.329
0.354
0.365
0.367
0.364
0.361
0.358
0.352

, p
2
=

¸
¸
¸
¸
¸
¸
¸
¸
¸
¸
¸
−0.722
−0.368
−0.121
0.044
0.161
0.291
0.316
0.343

, p
3
=

¸
¸
¸
¸
¸
¸
¸
¸
¸
¸
¸
0.490
−0.204
−0.455
−0.461
−0.176
0.176
0.268
0.404

.
• The first PC is roughly flat (parallel shift → average rate),
• the second PC is upward sloping (tilt → slope),
• the third PC hump-shaped (flex → curvature).
36 CHAPTER 3. STATISTICS OF THE YIELD CURVE
Figure 3.1: First Three PCs.
2 3 4 5 6 7 8
-0.8
-0.6
-0.4
-0.2
0.2
0.4
0.6
Table 3.1: Explained Variance of the Principal Components (PCs).
PC Explained
Variance (%)
1 92.17
2 6.93
3 0.61
4 0.24
5 0.03
6–8 0.01
The first three PCs explain more than 99 % of the variance of x (→Table 3.1).
PCA of the yield curve goes back to the seminal paper by Litterman
and Scheinkman (91) [17] (Prof. J. Scheinkman is at the Department of
Economics, Princeton University).
3.3 Correlation
→ R[22](p.58)
A typical example of correlation among forward rates is provided by
3.3. CORRELATION 37
Brown and Schaefer (1994). The data is from the US Treasury yield curve
1987–1994. The following matrix (→ Figure 3.2)

¸
¸
¸
¸
¸
¸
¸
1 0.87 0.74 0.69 0.64 0.6
1 0.96 0.93 0.9 0.85
1 0.99 0.95 0.92
1 0.97 0.93
1 0.95
1

shows the correlation for changes of forward rates of maturities
0, 0.5, 1, 1.5, 2, 3 years.
Figure 3.2: Correlation between the short rate and instantaneous forward
rates for the US Treasury curve 1987–1994
0.5 1 1.5 2 2.5 3
0.6
0.7
0.8
0.9
1
→ Decorrelation occurs quickly.
→ Exponentially decaying correlation structure is plausible.
38 CHAPTER 3. STATISTICS OF THE YIELD CURVE
Chapter 4
Estimating the Yield Curve
4.1 A Bootstrapping Example
→ JW[11](p.129–136)
This is a naive bootstrapping method of fitting to a money market yield
curve. The idea is to build up the yield curve
from shorter maturities to longer maturities.
We take Yen data from 9 January, 1996 (→ JW[11](Section 5.4)). The
spot date t
0
is 11 January, 1996. The day-count convention is Actual/360,
δ(T, S) =
actual number of days between T and S
360
.
Table 4.1: Yen data, 9 January 1996.
LIBOR (%) Futures Swaps (%)
o/n 0.49 20 Mar 96 99.34 2y 1.14
1w 0.50 19 Jun 96 99.25 3y 1.60
1m 0.53 18 Sep 96 99.10 4y 2.04
2m 0.55 18 Dec 96 98.90 5y 2.43
3m 0.56 7y 3.01
10y 3.36
39
40 CHAPTER 4. ESTIMATING THE YIELD CURVE
• The first column contains the LIBOR (=simple spot rates) F(t
0
, S
i
) for
maturities
¦S
1
, . . . , S
5
¦ = ¦12/1/96, 18/1/96, 13/2/96, 11/3/96, 11/4/96¦
hence for 1, 7, 33, 60 and 91 days to maturity, respectively. The zero-
coupon bonds are
P(t
0
, S
i
) =
1
1 +F(t
0
, S
i
) δ(t
0
, S
i
)
.
• The futures are quoted as
futures price for settlement day T
i
= 100(1 −F
F
(t
0
; T
i
, T
i+1
)),
where F
F
(t
0
; T
i
, T
i+1
) is the futures rate for period [T
i
, T
i+1
] prevailing
at t
0
, and
¦T
1
, . . . , T
5
¦ = ¦20/3/96, 19/6/96, 18/9/96, 18/12/96, 19/3/97¦,
hence δ(T
i
, T
i+1
) ≡ 91/360.
We treat futures rates as if they were simple forward rates, that is, we
set
F(t
0
; T
i
, T
i+1
) = F
F
(t
0
; T
i
, T
i+1
).
To calculate zero-coupon bond from futures prices we need P(t
0
, T
1
).
We use geometric interpoliation
P(t
0
, T
1
) = P(t
0
, S
4
)
q
P(t
0
, S
5
)
1−q
,
which is equivalent to using linear interpolation of continuously com-
pounded spot rates
R(t
0
, T
1
) = q R(t
0
, S
4
) + (1 −q) R(t
0
, S
5
),
where
q =
δ(T
1
, S
5
)
δ(S
4
, S
5
)
=
22
31
= 0.709677.
Then we use the relation
P(t
0
, T
i+1
) =
P(t
0
, T
i
)
1 +δ(T
i
, T
i+1
) F(t
0
; T
i
, T
i+1
)
to derive P(t
0
, T
2
), . . . , P(t
0
, T
5
).
4.1. A BOOTSTRAPPING EXAMPLE 41
• Yen swaps have semi-annual cashflows at dates
¦U
1
, . . . , U
20
¦ =

11/7/96, 13/1/97,
11/7/97, 12/1/98,
13/7/98, 11/1/99,
12/7/99, 11/1/00,
11/7/00, 11/1/01,
11/7/01, 11/1/02,
11/7/02, 13/1/03,
11/7/03, 12/1/04,
12/7/04, 11/1, 05,
11/7/05, 11/1/06

.
For a swap with maturity U
n
the swap rate at t
0
is given by
R
swap
(t
0
, U
n
) =
1 −P(t
0
, U
n
)
¸
n
i=1
δ(U
i−1
, U
i
) P(t
0
, U
i
)
, (U
0
:= t
0
).
From the data we have R
swap
(t
0
, U
i
) for i = 4, 6, 8, 10, 14, 20.
We obtain P(t
0
, U
1
), P(t
0
, U
2
) (and hence R
swap
(t
0
, U
1
), R
swap
(t
0
, U
2
))
by linear interpolation of the continuously compounded spot rates
R(t
0
, U
1
) =
69
91
R(t
0
, T
2
) +
22
91
R(t
0
, T
3
)
R(t
0
, U
2
) =
65
91
R(t
0
, T
4
) +
26
91
R(t
0
, T
5
).
All remaining swap rates are obtained by linear interpolation. For
maturity U
3
this is
R
swap
(t
0
, U
3
) =
1
2
(R
swap
(t
0
, U
2
) +R
swap
(t
0
, U
4
)).
We have (→ exercise)
P(t
0
, U
n
) =
1 −R
swap
(t
0
, U
n
)
¸
n−1
i=1
δ(U
i−1
, U
i
) P(t
0
, U
i
)
1 +R
swap
(t
0
, U
n
)δ(U
n−1
, U
n
)
.
This gives P(t
0
, U
n
) for n = 3, . . . , 20.
42 CHAPTER 4. ESTIMATING THE YIELD CURVE
Figure 4.1: Zero-coupon bond curve
2 4 6 8 10
Time to maturity
0.2
0.4
0.6
0.8
1
In Figure 4.1 is the implied zero-coupon bond price curve
P(t
0
, t
i
), i = 0, . . . , 29
(we have 29 points and set P(t
0
, t
0
) = 1).
The spot and forward rate curves are in Figure 4.2. Spot and forward
rates are continuously compounded
R(t
0
, t
i
) = −
log P(t
0
, t
i
)
δ(t
0
, t
i
)
R(t
0
, t
i
, t
i+1
) = −
log P(t
0
, t
i+1
) −log P(t
0
, t
i
)
δ(t
i
, t
i+1
)
, i = 1, . . . , 29.
The forward curve, reflecting the derivative of T → −log P(t
0
, T), is very
unsmooth and sensitive to slight variations (errors) in prices.
Figure 4.3 shows the spot rate curves from LIBOR, futures and swaps. It
is evident that the three curves are not coincident to a common underlying
curve. Our naive method made no attempt to meld the three curves together.
→ The entire yield curve is constructed from relatively few instruments. The
method exactly reconstructs market prices (this is desirable for interest
rate option traders). But it produces an unstable, non-smooth forward
curve.
4.1. A BOOTSTRAPPING EXAMPLE 43
Figure 4.2: Spot rates (lower curve), forward rates (upper curve)
2 4 6 8 10
Time to maturity
0.01
0.02
0.03
0.04
0.05
0.06
Figure 4.3: Comparison of money market curves
0.5 1 1.5 2
Time to maturity
0.005
0.006
0.007
0.008
0.009
0.01
0.011
0.012
→ Another method would be to estimate a smooth yield curve parametri-
cally from the market rates (for fund managers, long term strategies).
The main difficulties with our method are:
• Futures rates are treated as forward rates. In reality futures rates are
greater than forward rates. The amount by which the futures rate is
above the forward rate is called the convexity adjustment, which is
44 CHAPTER 4. ESTIMATING THE YIELD CURVE
model dependend. An example is
forward rate = futures rate −
1
2
σ
2
τ
2
,
where τ is the time to maturity of the futures contract, and σ is the
volatility parameter.
• LIBOR rates beyond the “stup date” T
1
= 20/3/96 (that is, at S
5
=
11/4/96) are ignored once P(t
0
, T
1
) is found. In general, the segments
of LIBOR, futures and swap markets overlap.
• Swap rates are inappropriately interpolated. The linear interpolation
produces a “sawtooth” in the forward rate curve. However, in some
markets intermediate swaps are indeed priced as if their prices were
found by linear interpolation.
4.2 General Case
The general problem of finding today’s (t
0
) term structure of zero-coupon
bond prices (or the discount function)
x → D(x) := P(t
0
, t
0
+x)
can be formulated as
p = C d +,
where p is a vector of n market prices, C the related cashflow matrix, and
d = (D(x
1
), . . . , D(x
N
)) with cashflow dates t
0
< T
1
< < T
N
,
T
i
−t
0
= x
i
,
and a vector of pricing errors. Reasons for including errors are
• prices are never exactly simultaneous,
• round-off errors in the quotes (bid-ask spreads, etc),
• liquidity effects,
• tax effects (high coupons, low coupons),
• allows for smoothing.
4.2. GENERAL CASE 45
4.2.1 Bond Markets
Data:
• vector of quoted/market bond prices p = (p
1
, . . . , p
n
),
• dates of all cashflows t
0
< T
1
< < T
N
,
• bond i with cashflows (coupon and principal payments) c
i,j
at time T
j
(may be zero), forming the n N cashflow matrix
C = (c
i,j
) 1≤i≤n
1≤j≤N
.
Example (→JW[11], p.426): UK government bond (gilt) market, Septem-
ber 4, 1996, selection of nine gilts. The coupon payments are semiannual.
The spot date is 4/9/96, and the day-count convention is actual/365.
Table 4.2: Market prices for UK gilts, 4/9/96.
coupon next maturity dirty price
(%) coupon date (p
i
)
bond 1 10 15/11/96 15/11/96 103.82
bond 2 9.75 19/01/97 19/01/98 106.04
bond 3 12.25 26/09/96 26/03/99 118.44
bond 4 9 03/03/97 03/03/00 106.28
bond 5 7 06/11/96 06/11/01 101.15
bond 6 9.75 27/02/97 27/08/02 111.06
bond 7 8.5 07/12/96 07/12/05 106.24
bond 8 7.75 08/03/97 08/09/06 98.49
bond 9 9 13/10/96 13/10/08 110.87
Hence n = 9 and N = 1 + 3 + 6 + 7 + 11 + 12 + 19 + 20 + 25 = 104,
T
1
= 26/09/96, T
2
= 13/10/96, T
3
= 06/11/97, . . . .
46 CHAPTER 4. ESTIMATING THE YIELD CURVE
No bonds have cashflows at the same date. The 9 104 cashflow matrix is
C =

¸
¸
¸
¸
¸
¸
¸
¸
¸
¸
¸
¸
¸
0 0 0 105 0 0 0 0 0 0 . . .
0 0 0 0 0 4.875 0 0 0 0 . . .
6.125 0 0 0 0 0 0 0 0 6.125 . . .
0 0 0 0 0 0 0 4.5 0 0 . . .
0 0 3.5 0 0 0 0 0 0 0 . . .
0 0 0 0 0 0 4.875 0 0 0 . . .
0 0 0 0 4.25 0 0 0 0 0 . . .
0 0 0 0 0 0 0 0 3.875 0 . . .
0 4.5 0 0 0 0 0 0 0 0 . . .

4.2.2 Money Markets
Money market data can be put into the same price–cashflow form as above.
LIBOR (rate L, maturity T): p = 1 and c = 1 + (T −t
0
)L at T.
FRA (forward rate F for [T, S]): p = 0, c
1
= −1 at T
1
= T, c
2
= 1+(S−T)F
at T
2
= S.
Swap (receiver, swap rate K, tenor t
0
≤ T
0
< < T
n
, T
i
− T
i−1
≡ δ):
since
0 = −D(T
0
−t
0
) +δK
n
¸
j=1
D(T
j
−t
0
) + (1 +δK)D(T
n
−t
0
),
• if T
0
= t
0
: p = 1, c
1
= = c
n−1
= δK, c
n
= 1 +δK,
• if T
0
> t
0
: p = 0, c
0
= −1, c
1
= = c
n−1
= δK, c
n
= 1 +δK.
→ at t
0
: LIBOR and swaps have notional price 1, FRAs and forward swaps
have notional price 0.
Example (→ JW[11], p.428): US money market on October 6, 1997.
The day-count convention is Actual/360. The spot date t
0
is 8/10/97.
LIBOR is for o/n (1/365), 1m (33/360), and 3m (92/360).
4.2. GENERAL CASE 47
Futures are three month rates (δ = 91/360). We take them as forward
rates. That is, the quote of the futures contract with maturity date (settle-
ment day) T is
100(1 −F(t
0
; T, T +δ)).
Swaps are annual (δ = 1). The first payment date is 8/10/98.
Table 4.3: US money market, October 6, 1997.
Period Rate Maturity Date
LIBOR o/n 5.59375 9/10/97
1m 5.625 10/11/97
3m 5.71875 8/1/98
Futures Oct-97 94.27 15/10/97
Nov-97 94.26 19/11/97
Dec-97 94.24 17/12/97
Mar-98 94.23 18/3/98
Jun-98 94.18 17/6/98
Sep-98 94.12 16/9/98
Dec-98 94 16/12/98
Swaps 2 6.01253
3 6.10823
4 6.16
5 6.22
7 6.32
10 6.42
15 6.56
20 6.56
30 6.56
Here n = 3 + 7 + 9 = 19, N = 3 + 14 + 30 = 47, T
1
= 9/10/97,
T
2
= 15/10/97 (first future), T
3
= 10/11/97, . . . . The first 14 columns of
48 CHAPTER 4. ESTIMATING THE YIELD CURVE
the 19 47 cashflow matrix C are
c
11
0 0 0 0 0 0 0 0 0 0 0 0 0
0 0 c
23
0 0 0 0 0 0 0 0 0 0 0
0 0 0 0 0 c
36
0 0 0 0 0 0 0 0
0 −1 0 0 0 0 c
47
0 0 0 0 0 0 0
0 0 0 −1 0 0 0 c
58
0 0 0 0 0 0
0 0 0 0 −1 0 0 0 c
69
0 0 0 0 0
0 0 0 0 0 0 0 0 −1 c
7,10
0 0 0 0
0 0 0 0 0 0 0 0 0 −1 c
8,11
0 0 0
0 0 0 0 0 0 0 0 0 0 −1 0 c
9,13
0
0 0 0 0 0 0 0 0 0 0 0 0 −1 c
10,14
0 0 0 0 0 0 0 0 0 0 0 c
11,12
0 0
0 0 0 0 0 0 0 0 0 0 0 c
12,12
0 0
0 0 0 0 0 0 0 0 0 0 0 c
13,12
0 0
0 0 0 0 0 0 0 0 0 0 0 c
14,12
0 0
0 0 0 0 0 0 0 0 0 0 0 c
15,12
0 0
0 0 0 0 0 0 0 0 0 0 0 c
16,12
0 0
0 0 0 0 0 0 0 0 0 0 0 c
17,12
0 0
0 0 0 0 0 0 0 0 0 0 0 c
18,12
0 0
0 0 0 0 0 0 0 0 0 0 0 c
19,12
0 0
with
c
11
= 1.00016, c
23
= 1.00516, c
36
= 1.01461,
c
47
= 1.01448, c
58
= 1.01451, c
69
= 1.01456, c
7,10
= 1.01459,
c
8,11
= 1.01471, c
9,13
= 1.01486, c
10,14
= 1.01517
c
11,12
= 0.060125, c
12,12
= 0.061082, c
13,12
= 0.0616,
c
14,12
= 0.0622, c
15,12
= 0.0632, c
16,12
= 0.0642,
c
17,12
= c
18,12
= c
19,12
= 0.0656.
4.2.3 Problems
Typically, we have n < N. Moreover, many entries of C are zero (different
cashflow dates). This makes ordinary least square (OLS) regression
min
d∈R
N
¦||
2
[ = p −C d¦ (⇒C
T
p = C
T
Cd

)
unfeasible.
4.2. GENERAL CASE 49
One could chose the data set such that cashflows are at same points in
time (say four dates each year) and the cashflow matrix C is not entirely full
of zeros (Carleton–Cooper (1976)). Still regression only yields values D(x
i
)
at the payment dates t
0
+x
i
→ interpolation technics necessary.
But there is nothing to regularize the discount factors (discount factors of
similar maturity can be very different). As a result this leads to a ragged
spot rate (yield) curve, and even worse for forward rates.
4.2.4 Parametrized Curve Families
Reduction of parameters and smooth yield curves can be achieved by using
parametrized families of smooth curves
D(x) = D(x; z) = exp

x
0
φ(u; z) du

, z ∈ Z,
with state space Z ⊂ R
m
.
For regularity reasons (see below) it is best to estimate the forward curve
R
+
÷ x → f(t
0
, t
0
+x) = φ(x) = φ(x; z).
This leads to a nonlinear optimization problem
min
z∈?
|p −C d(z)| ,
with
d
i
(z) = exp

x
i
0
φ(u; z) du

for some payment tenor 0 < x
1
< < x
N
.
Linear Families
Fix a set of basis functions ψ
1
, . . . , ψ
m
(preferably with compact support),
and let
φ(x; z) = z
1
ψ
1
(x) + + z
m
ψ
m
(x).
50 CHAPTER 4. ESTIMATING THE YIELD CURVE
Cubic B-splines A cubic spline is a piecewise cubic polynomial that is
everywhere twice differentiable. It interpolates values at m + 1 knot points
ξ
0
< < ξ
m
. Its general form is
σ(x) =
3
¸
i=0
a
i
x
i
+
m−1
¸
j=1
b
j
(x −ξ
j
)
3
+
,
hence it has m+3 parameters ¦a
0
, . . . , a
4
, b
1
, . . . , b
m−1
¦ (a kth degree spline
has m+k parameters). The spline is uniquely characterized by specification
of σ
t
or σ
tt
at ξ
0
and ξ
m
.
Introduce six extra knot points
ξ
−3
< ξ
−2
< ξ
−1
< ξ
0
< < ξ
m
< ξ
m+1
< ξ
m+2
< ξ
m+3
.
A basis for the cubic splines on [ξ
0
, ξ
m
] is given by the m + 3 B-splines
ψ
k
(x) =
k+4
¸
j=k

k+4
¸
i=k,i,=j
1
ξ
i
−ξ
j

(x −ξ
j
)
3
+
, k = −3, . . . , m−1.
The B-spline ψ
k
is zero outside [ξ
k
, ξ
k+4
].
Figure 4.4: B-spline with knot points ¦0, 1, 6, 8, 11¦.
2 4 6 8 10 12
0.01
0.02
0.03
0.04
0.05
0.06
4.2. GENERAL CASE 51
Estimating the Discount Function B-splines can also be used to esti-
mate the discount function directly (Steeley (1991)),
D(x; z) = z
1
ψ
1
(x) + +z
m
ψ
m
(x).
With
d(z) =

¸
¸
D(x
1
; z)
.
.
.
D(x
N
; z)

=

¸
¸
ψ
1
(x
1
) ψ
m
(x
1
)
.
.
.
.
.
.
ψ
1
(x
N
) ψ
m
(x
N
)

¸
¸
z
1
.
.
.
z
m

=: Ψ z
this leads to the linear optimization problem
min
z∈R
m
|p −CΨz|.
If the n m matrix A := CΨ has full rank m, the unique unconstrained
solution is
z

= (A
T
A)
−1
A
T
p.
A reasonable constraint would be
D(0; z) = ψ
1
(0)z
1
+ +ψ
m
(0)z
m
= 1.
Example We take the UK government bond market data from the last
section (Table 4.2). The maximum time to maturity, x
104
, is 12.11 [years].
Notice that the first bond is a zero-coupon bond. Its exact yield is
y = −
365
72
log
103.822
105
= −
1
0.197
log 0.989 = 0.0572.
• As a basis we use the 8 (resp. first 7) B-splines with the 12 knot points
¦−20, −5, −2, 0, 1, 6, 8, 11, 15, 20, 25, 30¦
(see Figure 4.5).
The estimation with all 8 B-splines leads to
min
z∈R
8
|p −CΨz| = |p −CΨz

| = 0.23
52 CHAPTER 4. ESTIMATING THE YIELD CURVE
Figure 4.5: B-splines with knots ¦−20, −5, −2, 0, 1, 6, 8, 11, 15, 20, 25, 30¦.
5 10 15 20 25 30
0.01
0.02
0.03
0.04
0.05
0.06
0.07
with
z

=

¸
¸
¸
¸
¸
¸
¸
¸
¸
¸
¸
13.8641
11.4665
8.49629
7.69741
6.98066
6.23383
−4.9717
855.074

,
and the discount function, yield curve (cont. comp. spot rates), and for-
ward curve (cont. comp. 3-monthly forward rates) shown in Figure 4.7.
The estimation with only the first 7 B-splines leads to
min
z∈R
7
|p −CΨz| = |p −CΨz

| = 0.32
with
z

=

¸
¸
¸
¸
¸
¸
¸
¸
¸
17.8019
11.3603
8.57992
7.56562
7.28853
5.38766
4.9919

,
4.2. GENERAL CASE 53
and the discount function, yield curve (cont. comp. spot rates), and
forward curve (cont. comp. 3-month forward rates) shown in Figure 4.8.
• Next we use only 5 B-splines with the 9 knot points
¦−10, −5, −2, 0, 4, 15, 20, 25, 30¦
(see Figure 4.6).
Figure 4.6: Five B-splines with knot points ¦−10, −5, −2, 0, 4, 15, 20, 25, 30¦.
5 10 15 20 25 30
0.005
0.01
0.015
0.02
0.025
0.03
0.035
The estimation with this 5 B-splines leads to
min
z∈R
5
|p −CΨz| = |p −CΨz

| = 0.39
with
z

=

¸
¸
¸
¸
¸
15.652
19.4385
12.9886
7.40296
6.23152

,
and the discount function, yield curve (cont. comp. spot rates), and for-
ward curve (cont. comp. 3-monthly forward rates) shown in Figure 4.9.
54 CHAPTER 4. ESTIMATING THE YIELD CURVE
Figure 4.7: Discount function, yield and forward curves for estimation with
8 B-splines. The dot is the exact yield of the first bond.
2 4 6 8 10 12
0.2
0.4
0.6
0.8
1
2 4 6 8 10 12
0.02
0.04
0.06
0.08
0.1
0.12
0.14
2 4 6 8 10 12
0.05
0.1
0.15
0.2
0.25
4.2. GENERAL CASE 55
Figure 4.8: Discount function, yield and forward curves for estimation with
7 B-splines. The dot is the exact yield of the first bond.
2 4 6 8 10 12
0.2
0.4
0.6
0.8
1
2 4 6 8 10 12
0.02
0.04
0.06
0.08
0.1
0.12
0.14
2 4 6 8 10 12
0.05
0.1
0.15
0.2
0.25
56 CHAPTER 4. ESTIMATING THE YIELD CURVE
Figure 4.9: Discount function, yield and forward curves for estimation with
5 B-splines. The dot is the exact yield of the first bond.
2 4 6 8 10 12
0.2
0.4
0.6
0.8
1
2 4 6 8 10 12
0.02
0.04
0.06
0.08
0.1
0.12
0.14
2 4 6 8 10 12
0.05
0.1
0.15
0.2
0.25
4.2. GENERAL CASE 57
Discussion
• In general, splines can produce bad fits.
• Estimating the discount function leads to unstable and non-smooth
yield and forward curves. Problems mostly at short and long term
maturities.
• Splines are not useful for extrapolating to long term maturities.
• There is a trade-off between the quality (or regularity) and the correct-
ness of the fit. The curves in Figures 4.8 and 4.9 are more regular than
those in Figure 4.7, but their correctness criteria (0.32 and 0.39) are
worse than for the fit with 8 B-splines (0.23).
• The B-spline fits are extremely sensitive to the number and location of
the knot points.
→ Need criterions asserting smooth yield and forward curves that do not
fluctuate too much and flatten towards the long end.
→ Direct estimation of the yield or forward curve.
→ Optimal selection of number and location of knot points for splines.
→ Smoothing splines.
Smoothing Splines The least squares criterion
min
z
|p −C d(z)|
2
has to be replaced/extended by criterions for the smoothness of the yield or
forward curve.
Example: Lorimier (95). In her PhD thesis 1995, Sabine Lorimier sug-
gests a spline method where the number and location of the knots are deter-
mined by the observed data itself.
For ease of notation we set t
0
= 0 (today). The data is given by N
observed zero-coupon bonds P(0, T
1
), . . . , P(0, T
N
) at 0 < T
1
< < T
N

T, and consequently the N yields
Y
1
, . . . , Y
N
, P(0, T
i
) = exp(−T
i
Y
i
).
58 CHAPTER 4. ESTIMATING THE YIELD CURVE
Let f(u) denote the forward curve. The fitting requirement now is for the
forward curve

T
i
0
f(u) du +
i
/

α = T
i
Y
i
, (4.1)
with an arbitrary constant α > 0. The aim is to minimize ||
2
as well as the
smoothness criterion

T
0
(f
t
(u))
2
du. (4.2)
Introduce the Sobolev space
H = ¦g [ g
t
∈ L
2
[0, T]¦
with scalar product
'g, h`
H
= g(0)h(0) +

T
0
g
t
(u)h
t
(u) du,
and the nonlinear functional on H
F(f) :=
¸

T
0
(f
t
(u))
2
du +α
N
¸
i=1

Y
i
T
i

T
i
0
f(u) du

2
¸
.
The optimization problem then is
min
f∈H
F(f). (*)
The parameter α tunes the trade-off between smoothness and correctness of
the fit.
Theorem 4.2.1. Problem (*) has a unique solution f, which is a second
order spline characterized by
f(u) = f(0) +
N
¸
k=1
a
k
h
k
(u) (4.3)
where h
k
∈ C
1
[0, T] is a second order polynomial on [0, T
k
] with
h
t
k
(u) = (T
k
−u)
+
, h
k
(0) = T
k
, k = 1, . . . , N, (4.4)
4.2. GENERAL CASE 59
and f(0) and a
k
solve the linear system of equations
N
¸
k=1
a
k
T
k
= 0, (4.5)
α

Y
k
T
k
−f(0)T
k

N
¸
l=1
a
l
'h
l
, h
k
`
H

= a
k
, k = 1, . . . , N. (4.6)
Proof. Integration by parts yields

T
k
0
g(u) du = T
k
g(T
k
) −

T
k
0
ug
t
(u) du
= T
k
g(0) +T
k

T
k
0
g
t
(u) du −

T
k
0
ug
t
(u) du
= T
k
g(0) +

T
0
(T
k
−u)
+
g
t
(u) du = 'h
k
, g`
H
,
for all g ∈ H. In particular,

T
k
0
h
l
du = 'h
l
, h
k
`
H
.
A (local) minimizer f of F satisfies
d
d
F(f +g)[
=0
= 0
or equivalently

T
0
f
t
g
t
du = α
N
¸
k=1

Y
k
T
k

T
k
0
f du

T
k
0
g du, ∀g ∈ H. (4.7)
In particular, for all g ∈ H with 'g, h
k
`
H
= 0 we obtain
'f −f(0), g`
H
=

T
0
f
t
(u)g
t
(u) du = 0.
Hence
f −f(0) ∈ span¦h
1
, . . . , h
N
¦
60 CHAPTER 4. ESTIMATING THE YIELD CURVE
what proves (4.3), (4.4) and (4.5) (set u = 0). Hence we have

T
0
f
t
(u)g
t
(u) du =
N
¸
k=1
a
k

−T
k
g(0) +

T
k
0
g(u) du

=
N
¸
k=1
a
k

T
k
0
g(u) du,
and (4.7) can be rewritten as
N
¸
k=1

a
k
−α

Y
k
T
k
−f(0)T
k

N
¸
l=1
a
l
'h
l
, h
k
`
H

T
k
0
g(u) du = 0
for all g ∈ H. This is true if and only if (4.6) holds.
Thus we have shown that (4.7) is equivalent to (4.3)–(4.6).
Next we show that (4.7) is a sufficient condition for f to be a global
minimizer of F. Let g ∈ H, then
F(g) =

T
0
((g
t
−f
t
) +f
t
)
2
du +α
N
¸
k=1

Y
k
T
k

T
k
0
g du

2
(4.7)
= F(f) +

T
0
(g
t
−f
t
)
2
du +α
N
¸
k=1

T
k
0
f du −

T
k
0
g du

2
≥ F(f),
where we used (4.7) with g −f ∈ H.
It remains to show that f exists and is unique; that is, that the linear sys-
tem (4.5)–(4.6) has a unique solution (f(0), a
1
, . . . , a
N
). The corresponding
(N + 1) (N + 1) matrix is
A =

¸
¸
¸
¸
0 T
1
T
2
T
N
αT
1
α'h
1
, h
1
`
H
+ 1 α'h
1
, h
2
`
H
α'h
1
, h
N
`
H
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
αT
N
α'h
N
, h
1
`
H
α'h
N
, h
2
`
H
α'h
N
, h
N
`
H
+ 1

. (4.8)
Let λ = (λ
0
, . . . , λ
N
)
T
∈ R
N+1
such that Aλ = 0, that is,
N
¸
k=1
T
k
λ
k
= 0
αT
k
λ
0

N
¸
l=1
'h
k
, h
l
`
H
λ
l

k
= 0, k = 1, . . . , N.
4.2. GENERAL CASE 61
Multiplying the latter equation with λ
k
and summing up yields
α

N
¸
k=1
λ
k
h
k

2
H
+
N
¸
k=1
λ
2
k
= 0.
Hence λ = 0, whence A is non-singular.
The role of α is as follows:
• If α → 0 then by (4.3) and (4.6) we have f(u) ≡ f(0), a constant
function. That is, maximal regularity

T
0
(f
t
(u))
2
du = 0
but no fitting of data, see (4.1).
• If α →∞ then (4.7) implies that

T
k
0
f(u) du = Y
k
T
k
, k = 1, . . . , N, (4.9)
a perfect fit. That is, f minimizes (4.2) subject to the constraints (4.9).
To estimate the forward curve from N zero-coupon bonds—that is, yields
Y = (Y
1
, . . . , Y
N
)
T
—one has to solve the linear system
A

f(0)
a

=

0
Y

(see (4.8)).
Of course, if coupon bond prices are given, then the above method has
to be modified and becomes nonlinear. With p ∈ R
n
denoting the market
price vector and c
kl
the cashflows at dates T
l
, k = 1, . . . , n, l = 1, . . . , N, this
reads
min
f∈H

T
0
(f
t
)
2
du +α
n
¸
k=1

log p
k
−log
¸
N
¸
l=1
c
kl
exp
¸

T
l
0
f du

¸
2

.
If the coupon payments are small compared to the nominal (=1), then this
problem has a unique solution. This and much more is carried out in Lorim-
ier’s thesis.
62 CHAPTER 4. ESTIMATING THE YIELD CURVE
Exponential-Polynomial Families
Exponential-polynomial functions
p
1
(x)e
−α
1
x
+ +p
n
(x)e
−αnx
(p
i
=polynomial of degree n
i
)
form non-linear families of functions. Popular examples are:
Nelson–Siegel (87) [20] There are 4 parameters z
1
, . . . , z
4
and
φ
NS
(x; z) = z
1
+ (z
2
+z
3
x)e
−z
4
x
.
Svensson (94) [26] (Prof. L. E. O. Svensson is at the Economics Depart-
ment, Princeton University) This is an extension of Nelson–Siegel, in-
cluding 6 parameters z
1
, . . . , z
6
,
φ
S
(x; z) = z
1
+ (z
2
+z
3
x)e
−z
4
x
+z
5
e
−z
6
x
.
Figure 4.10: Nelson–Siegel curves for z
1
= 7.69, z
2
= −4.13, z
4
= 0.5 and 7
different values for z
3
= 1.76, 0.77, −0.22, −1.21, −2.2, −3.19, −4.18.
5 10 15 20
2
4
6
8
Table 4.4 is taken from a document of the Bank for International Settle-
ments (BIS) 1999 [2].
4.2. GENERAL CASE 63
Table 4.4: Overview of estimation procedures by several central banks. BIS
1999 [2]. NS is for Nelson–Siegel, S for Svensson, wp for weighted prices.
Central Bank Method Minimized Error
Belgium S or NS wp
Canada S sp
Finland NS wp
France S or NS wp
Germany S yields
Italy NS wp
Japan smoothing prices
splines
Norway S yields
Spain S wp
Sweden S yields
UK S yields
USA smoothing bills: wp
splines bonds: prices
Criteria for Curve Families
• Flexibility (do the curves fit a wide range of term structures?)
• Number of factors not too large (curse of dimensionality).
• Regularity (smooth yield or forward curves that flatten out towards the
long end).
• Consistency: do the curve families go well with interest rate models?
→ this point will be exploited in the sequel.
64 CHAPTER 4. ESTIMATING THE YIELD CURVE
Chapter 5
Why Yield Curve Models?
→ R[22](Chapter 5)
Why modelling the entire term structure of interest rates? There is no
need when pricing a single European call option on a bond.
But: the payoffs even of “plain-vanilla” fixed income products such as caps,
floors, swaptions consist of a sequence of cashflows at T
1
, . . . , T
n
, where
n may be 20 (e.g. a 10y swap with semi-annual payments) or more.
→ The valuation of such products requires the modelling of the entire covari-
ance structure. Historical estimation of such large covariance matrices
is statistically not tractable anymore.
→ Need strong structure to be imposed on the co-movements of financial
quantities of interest.
→ Specify the dynamics of a small number of variables (e.g. PCA).
→ Correlation structure among observable quantities can now be obtained
analytically or numerically.
→ Simultaneous pricing of different options and hedging instruments in a
consistent framework.
This is exactly what interest rate (curve) models offer:
• reduction of fitting degrees of freedom → makes problem manageable.
=⇒ It is practically and intellectually rewarding to consider no-arbitrage
conditions in much broader generality.
65
66 CHAPTER 5. WHY YIELD CURVE MODELS?
Chapter 6
No-Arbitrage Pricing
This chapter briefly recalls the basics about pricing and hedging in a Brown-
ian motion driven market. Reference is B[3], MR[19](Chapter 10), and many
more.
6.1 Self-Financing Portfolios
The stochastic basis is a probability space (Ω, T, P), a d-dimensional Brow-
nian motion W = (W
1
, . . . , W
d
), and the filtration (T
t
)
t≥0
generated by W.
We shall assume that T = T

= ∨
t≥0
T
t
, and do not a priori fix a finite
time horizon. This is not a restriction since always one can set a stochastic
process to be zero after a finite time T if this were the ultimate time horizon
(as in the Black–Scholes model).
The background for stochastic analysis can be found in many textbooks,
such as [14], [25], [23], etc. From time to time we recall some of the funda-
mental results without proof.
Financial Market We consider a financial market with n traded assets,
following strictly positive Itˆ o processes
dS
i
(t) = S
i
(t)µ
i
(t) dt +
d
¸
j=1
S
i
(t)σ
ij
(t) dW
j
(t), S
i
> 0, i = 1, . . . , n
and the risk-free asset
dS
0
(t) = r(t)S
0
(t) dt, S
0
(0) = 1

⇔S
0
(t) = e

t
0
r(s) ds

.
67
68 CHAPTER 6. NO-ARBITRAGE PRICING
The drift µ = (µ
1
, . . . , µ
n
), volatility σ = (σ
ij
), and short rates r are assumed
to form adapted processes which meet the required integrability conditions
such that all of the above (stochastic) integrals are well-defined.
Remark 6.1.1. It is always understood that for a random variable “X ≥ 0”
means “X ≥ 0 a.s.” (that is, P[X ≥ 0] = 1), etc.
Theorem 6.1.2 (Stochastic Integrals). Let h = (h
1
, . . . , h
d
) be a mea-
surable adapted process. If

t
0
|h(s)|
2
ds < ∞ for all t > 0
(the class of such processes is denoted by L) one can define the stochastic
integral
(h W)
t

t
0
h(s) dW(s) ≡
d
¸
j=1

t
0
h
j
(s) dW
j
(s).
If moreover
E
¸

0
|h(s)|
2
ds

< ∞
(the class of such processes is denoted by L
2
) then h W is a martingale and
the Itˆ o isometry holds
E
¸

t
0
h(s) dW(s)

2
¸
= E
¸
t
0
|h(s)|
2
ds

.
Self-financing Portfolios A portfolio, or trading strategy, is any adapted
process
φ = (φ
0
, . . . , φ
n
).
Its corresponding value process is
V (t) = V (t; φ) :=
n
¸
i=0
φ
i
(t)S
i
(t).
The portfolio φ is called self-financing (for S) if the stochastic integrals

t
0
φ
i
(u) dS
i
(u), i = 0, . . . , n
6.2. ARBITRAGE AND MARTINGALE MEASURES 69
are well defined and
dV (t; φ) =
n
¸
i=0
φ
i
(t) dS
i
(t).
Numeraires All prices are interpreted as being given in terms of a nu-
meraire, which typically is a local currency such as US dollars. But we may
and will express from time to time the prices in terms of other numeraires,
such as S
p
for some 0 ≤ p ≤ n. The discounted price process vector
Z(t) :=
S(t)
S
p
(t)
implies the discounted value process
˜
V (t; φ) :=
n
¸
i=0
φ
i
(t)Z
i
(t) =
V (t; φ)
S
p
(t)
.
Up to integrability, the self-financing property does not depend on the choice
of the numeraire.
Lemma 6.1.3. Suppose that a portfolio φ satisfies the integrability conditions
for S and Z. Then φ is self-financing for S if and only if it is self-financing
for Z, in particular
d
˜
V (t; φ) =
n
¸
i=0
φ
i
(t) dZ
i
(t) =
n
¸
i=0
i=p
φ
i
(t) dZ
i
(t). (6.1)
Since Z
p
is constant, the number of terms in (6.1) reduces to n.
Often (but not always) we chose S
0
as the numeraire.
6.2 Arbitrage and Martingale Measures
Contingent Claims Related to any option (such as a cap, floor, swaption,
etc) is an uncertain future payoff, say at date T, hence an T
T
-measurable
random variable X (a contingent (T-)claim). Two main problems now are:
• What is a “fair” price for a contingent claim X?
• How can one hedge against the financial risk involved in trading con-
tingent claims?
70 CHAPTER 6. NO-ARBITRAGE PRICING
Arbitrage An arbitrage portfolio is a self-financing portfolio φ with value
process satisfying
V (0) = 0 and V (T) ≥ 0 and P[V (T) > 0] > 0
for some T > 0. If no arbitrage portfolios exist for any T > 0 we say the
model is arbitrage-free.
An example of arbitrage is the following.
Lemma 6.2.1. Suppose there exists a self-financing portfolio with value pro-
cess
dU(t) = k(t)U(t) dt,
for some measurable adapted process k. If the market is arbitrage-free then
necessarily
r = k, dt ⊗dP-a.s.
Proof. Indeed, after discounting with S
0
we obtain
˜
U(t) :=
U(t)
S
0
(t)
= U(0) exp

t
0
(k(s) −r(s)) ds

.
Then (→ exercise)
ψ(t) := 1
|k(t)>r(t)¦
yields a self-financing strategy with discounted value process
˜
V (t) =

t
0
ψ(s) d
˜
U(s) =

t
0

1
|k(s)>r(s)¦
(k(s) −r(s))
˜
U(s)

ds ≥ 0.
Hence absence of arbitrage requires
0 = E[
˜
V (T)] =

A

1
|k(t,ω)>r(t,ω)¦
(k(t, ω) −r(t, ω))
˜
U(t, ω)

. .. .
>0 on A
dt ⊗dP
where
^ := ¦(t, ω) [ k(t, ω) > r(t, ω)¦
is a measurable subset of [0, T] Ω. But this can only hold if ^ is a dt ⊗dP-
nullset. Using the same arguments with changed signs proves the lemma.
6.2. ARBITRAGE AND MARTINGALE MEASURES 71
Martingale Measures We now investigate when a given model is arbi-
trage-free. To simplify things in the sequel
• we fix S
0
as a numeraire, and

˜
V will express the discounted value process V/S
0
.
But the following can be made valid for any choice of numeraire.
An equivalent probability measure Q ∼ P is called an equivalent (local)
martingale measure (E(L)MM) if the discounted price processes
Z
i
= S
i
/S
0
are Q-(local) martingales.
Theorem 6.2.2 (Girsanov’s Change of Measure Theorem). Let Q ∼ P
be an equivalent probability measure. Then there exists γ ∈ L such that the
density process dQ/dP is the stochastic exponential c(γ W) of γ W
dQ
dP
[
Tt
= c
t
(γ W) := exp

t
0
γ(s) dW(s) −
1
2

t
0
|γ(s)|
2
ds

. (6.2)
Moreover, the process
˜
W(t) := W(t) −

t
0
γ(s) ds (6.3)
is a Q-Brownian motion.
Conversely, if γ ∈ L is such that c (γ W) is a uniformly integrable
martingale with c

(γ W) > 0 — sufficient is the Novikov condition
E
¸
exp

1
2


0
|γ(s)|
2
ds

< ∞ (6.4)
(see [23, Proposition (1.26), Chapter IV]) — then (6.2) defines an equivalent
probability measure Q ∼ P.
Market Price of Risk Let Q be an ELMM and γ (the stochastic logarithm
of the density process) and
˜
W given by (6.2) and (6.3). Integration by parts
yields the Z-dynamics
dZ
i
(t) = Z
i
(t) (µ
i
(t) −r(t)) dt +Z
i
(t)σ
i
(t) dW(t)
= Z
i
(t) (µ
i
(t) −r(t) +σ
i
(t) γ(t)) dt +Z
i
(t)σ
i
(t) d
˜
W(t).
72 CHAPTER 6. NO-ARBITRAGE PRICING
Hence necessarily γ satisfies
µ
i
−r +σ
i
γ = 0 dt ⊗dQ-a.s. for all i = 1, . . . , n. (6.5)
If σ is non-degenerate (in particular d ≤ n and rank[σ] = d) then γ is
uniquely specified by
−γ = σ
−1
(µ −r1)
where 1 := (1, . . . , 1)
T
, and vice versa. This is why −γ is called the market
price of risk.
Conversely, if (6.5) has a solution γ ∈ L such that c(γ W) is a uniformly
integrable martingale (the Novikov condition (6.4) is sufficient) then (6.2)
defines an ELMM Q. If γ is unique then Q is the unique ELMM.
Notice that, by Itˆ o’s formula, Z
i
can be written as stochastic exponential
Z
i
= c(σ
i

˜
W).
Hence if σ
i
satisfies the Novikov condition (6.4) for all i = 1, . . . , n then the
ELMM Q is in fact an EMM.
Admissible Strategies In the presence of local martingales one has to be
alert to pitfalls. For example it is possible to construct a local martingale M
with M(0) = 0 and M(1) = 1. Even worse, M can be chosen to be of the
form
M(t) =

t
0
φ(s) dW(s)
(Dudley’s Representation Theorem), which looks like the (discounted) value
process of a self-financing strategy. This would certainly be a money-making
machine, say arbitrage. In the same way “suicide strategies” (e.g. M(0) = 1
and M(1) = 0) can be constructed. To rule out such examples we have to
impose additional constraints on the choice of strategies. There are several
ways to do so. Here are two typical examples:
A self-financing strategy φ is admissible if
1.
˜
V (t; φ) ≥ −a for some a ∈ R, OR
2.
˜
V (t; φ) is a true Q-martingale, for some ELMM Q.
Condition 1 is more universal (it does not depend on a particular Q) and
implies that V (t; φ) is a Q-supermartingale for every ELMMQ. Yet, “suicide
strategies” remain (however, they do not introduce arbitrage).
Both conditions 1 and 2, however, are sensitive with respect to the choice
of numeraire!
6.3. HEDGING AND PRICING 73
The Fundamental Theorem of Asset Pricing The existence of an
ELMM rules out arbitrage.
Lemma 6.2.3. Suppose there exists an ELMM Q. Then the model is arbi-
trage-free, in the sense that there exists no admissible (either Condition 1 or
2) arbitrage strategy.
Proof. Indeed, let
˜
V be the discounted value process of an admissible strat-
egy, with
˜
V (0) = 0 and
˜
V (T) ≥ 0. Since
˜
V is a Q-supermartingale in any
case (for some ELMM Q), we have
0 ≤ E
Q
[
˜
V (T)] ≤
˜
V (0) = 0,
whence
˜
V (T) = 0.
It is folklore (Delbaen and Schachermayer 1994, etc) that also the converse
holds true: if arbitrage is defined in the right way (“No Free Lunch with
Vanishing Risk”), then its absence implies the existence of an ELMM Q.
This is called the Fundamental Theorem of Asset Pricing.
It has become a custom (and we will follow this tradition) to consider the
existence of an ELMM as synonym for the absence of arbitrage:
absence of arbitrage = existence of an ELMM;
→ the existence of an ELMM is now a standing assumption.
6.3 Hedging and Pricing
Attainable Claims A contingent claim X due at T is attainable if the
exists an admissible strategy φ which replicates/hedges X; that is,
V (T; φ) = X.
A simple example: suppose S
1
is the price process of the T-bond. Then
the contingent claim X = 1 due at T is attainable by an obvious buy and
hold strategy with value process V (t) = S
1
(t).
74 CHAPTER 6. NO-ARBITRAGE PRICING
Complete Markets The main problem is to determine which claims are
attainable. This is most conveniently carried out in terms of discounted
prices.
Suppose that σ is non-degenerate; that is
d ≤ n and rank[σ] = d, (6.6)
and that the unique market price of risk −γ given by (6.5) yields a uniformly
integrable martingale c(γ W) and hence a unique ELMM Q.
Lemma 6.3.1. Then the model is complete in the sense that any contingent
claim X with
X/S
0
(T) ∈ L
1
(T
T
; Q) (6.7)
is attainable.
Proof. Define the Q-martingale
Y (t) := E
Q
[X/S
0
(T) [ T
t
] , t ∈ [0, T].
Then
Y (t)D(t) = D(t)E
Q
[Y (T) [ T
t
]
Bayes
= E[Y (T)D(T) [ T
t
],
with the density process D(t) = dQ/dP[
Tt
= c
t
(γ W). Hence Y D is a P-
martingale and by the representation theorem 6.3.3 we can find ψ ∈ L such
that
Y (t)D(t) = Y (0) +

t
0
ψ(s) dW(s).
Applying Itˆ o’s formula yields
d

1
D

= −
1
D
γ dW +
1
D
|γ|
2
dt,
and
dY = d

(Y D)
1
D

= Y Dd

1
D

+
1
D
d(Y D) +d

Y D,
1
D

=

1
D
ψ −Y γ

dW −

1
D
ψ −Y γ

γ dt
=

1
D
ψ −Y γ

. .. .
=:
˜
ψ
d
˜
W.
6.3. HEDGING AND PRICING 75
Now define
φ
i
=
((σ
−1
)
T
˜
ψ)
i
Z
i
, (6.8)
then it follows that
n
¸
i=1
φ
i
dZ
i
=
n
¸
i=1
φ
i
Z
i
σ
i
d
˜
W = (σ
−1
)
T
˜
ψ σ d
˜
W =
˜
ψ σ
−1
σ d
˜
W =
˜
ψ d
˜
W = dY.
Hence φ yields an admissible strategy with discounted value process satisfying
˜
V (T; φ) = Y (T) = E
Q
[X/S
0
(T)] +
n
¸
i=1

T
0
φ
i
(s) dZ
i
(s) = X/S
0
(T). (6.9)
Hence non-degeneracy of σ (see (6.6) and (6.8)) implies uniqueness of Q
and completeness of the model. These conditions are in fact equivalent (see
for example MR[19](Chapter 10)).
Theorem 6.3.2 (Completeness). The following are equivalent:
1. the model is complete;
2. σ is non-degenerate, see (6.6);
3. there exists a unique ELMM Q.
Theorem 6.3.3 (Representation Theorem). Every P-local martingale
M has a continuous version and there exists ψ ∈ L such that
M(t) = M(0) +

t
0
ψ(s) dW(s).
(This theorem requires the filtration (T
t
) to be generated by W.)
Pricing In the above complete model the fair price prevailing at t ≤ T of
a T-claim X which satisfies (6.7) is given by (6.9)
V (t, φ) = S
0
(t)
˜
V (t; φ) = S
0
(t)E
Q
[X/S
0
(T) [ T
t
] . (6.10)
We shall often encounter complete models. However, models can be gener-
ically incomplete (as real markets are), and then the pricing becomes a dif-
ficult issue. The literature on incomplete markets is huge, and the topic
beyond the scope of this course.
76 CHAPTER 6. NO-ARBITRAGE PRICING
State-price Density It is a custom (e.g. for short rate models) to exoge-
nously specify a particular ELMM Q (or equivalently, the market price of
risk) and then price a T-claim X satisfying (6.7) according to (6.10)
price of X at t =: Y (t) = S
0
(t)E
Q
[X/S
0
(T) [ T
t
] .
This is a consistent pricing rule in the sense that the enlarged market
Y, S
0
, . . . , S
n
is still arbitrage-free (why?).
Now define
π(t) :=
1
S
0
(t)
dQ
dP
[
Tt
.
By Bayes formula we then have
Y (t) = S
0
(t)E
Q
[X/S
0
(T) [ T
t
] = S
0
(t)
E

X
S
0
(T)
dQ
dP
[
T
T
[ T
t

dQ
dP
[
Tt
=
E[Xπ(T) [ T
t
]
π(t)
,
and, in particular, for the price at t = 0
Y (0) = E[Xπ(T)].
This is why π is called the state-price density process.
The price of a T-bond for example is (if 1/S
0
(T) ∈ L
1
(Q), → exercise)
P(t, T) = E
¸
π(T)
π(t)
[ T
t

= E
Q
¸
S
0
(t)
S
0
(T)
[ T
t

.
Also one can check (→ exercise) that if Q is an EMM then
S
i
π are P-martingales.
Chapter 7
Short Rate Models
→ B[3](Chapters 16–17), MR[19](Chapter 12), etc
7.1 Generalities
Short rate models are the classical interest rate models. As in the last sec-
tion we fix a stochastic basis (Ω, T, P), where P is considered as objective
probability measure. The filtration (T
t
)
t≥0
is generated by a d-dimensional
Brownian motion W.
We assume that
• the short rates follow an Itˆ o process
dr(t) = b(t) dt +σ(t) dW(t)
determining the savings account B(t) = exp

t
0
r(s) ds

,
• all zero-coupon bond prices (P(t, T))
t∈[0,T]
are adapted processes (with
P(T, T) = 1 as usual),
• no-arbitrage: there exists an EMM Q, such that
P(t, T)
B(t)
, t ∈ [0, T],
is a Q-martingale for all T > 0.
77
78 CHAPTER 7. SHORT RATE MODELS
According to the last chapter, the existence of an ELMM for all T-bonds
excludes arbitrage among every finite selection of zero-coupon bonds, say
P(t, T
1
), . . . , P(t, T
n
). To be more general one would have to consider strate-
gies involving a continuum of bonds. This can be done (see [4] or Mike
Tehranchi’s PhD thesis 2002) but is beyond the scope of this course.
For convenience we require Q to be an EMM (and not merely an ELMM)
because then we have
P(t, T) = E
Q

e

T
t
r(s) ds
[ T
t

(7.1)
(compare this to the last section). Let −γ denote the corresponding market
price of risk
c
t
(γ W) =
dQ
dP
[
Tt
and
˜
W = W −

γ dt the implied Q-Brownian motion.
Proposition 7.1.1. Under the above assumptions, the process r satisfies
under Q
dr(t) = (b(t) +σ(t) γ(t)) dt +σ(t) d
˜
W(t). (7.2)
Moreover, for any T > 0 there exists an adapted R
d
-valued process σ
γ
(t, T),
t ∈ [0, T], such that
dP(t, T)
P(t, T)
= r(t) dt +σ
γ
(t, T) d
˜
W(t) (7.3)
and hence
P(t, T)
B(t)
= P(0, T)c
t

σ
γ

˜
W

.
Proof. Exercise (proceed as in the Completeness Lemma 6.3.1).
It follows from (7.3) that the T-bond price satisfies under the objective
probability measure P
dP(t, T)
P(t, T)
= (r(t) −γ(t) σ
γ
(t, T)) dt +σ
γ
dW(t).
This illustrates again the role of the market price of risk −γ as the excess of
instantaneous return over r(t) in units of volatility.
7.2. DIFFUSION SHORT RATE MODELS 79
In a general equilibrium framework, the market price of risk is given
endogenously (as it is carried out in the seminal paper by Cox, Ingersoll and
Ross (85) [7]). Since our arguments refer only to the absence of arbitrage
between primary securities (bonds) and derivatives, we are unable to identify
the market price of risk. In other words, we started by specifying the P-
dynamics of the short rates, and hence the savings account B(t). However,
the savings account alone cannot be used to replicate bond payoffs: the
model is incomplete. According to the Completeness Theorem 6.3.2, this is
also reflected by the non-uniqueness of the EMM (the market price of risk).
A priori, Q can be any equivalent probability measure Q ∼ P.
A short rate model is not fully determined without the exogenous
specification of the market price of risk.
It is custom (and we follow this tradition) to postulate the Q-dynamics
(Q being the EMM) of r which implies the Q-dynamics of all bond prices
by (7.1), see also (7.3). All contingent claims can be priced by taking Q-
expectations of their discounted payoffs. The market price of risk (and hence
the objective measure P) can be inferred by statistical methods from histor-
ical observations of price movements.
7.2 Diffusion Short Rate Models
We fix a stochastic basis (Ω, T, (T
t
)
t≥0
, Q), where now Q is considered as
martingale measure. We let W denote a d-dimensional (Q, T
t
)-Brownian
motion.
Let Z ⊂ R be a closed interval, and b and σ continuous functions on
R
+
Z. We assume that for any ρ ∈ Z the stochastic differential equation
(SDE)
dr(t) = b(t, r(t)) dt +σ(t, r(t)) dW(t) (7.4)
admits a unique Z-valued solution r = r
ρ
with
r(t) = ρ +

t
0
b(u, r(u)) du +

t
0
σ(u, r(u)) dW(u)
and such that
exp

T
t
r(u) du

∈ L
1
(Q) (7.5)
80 CHAPTER 7. SHORT RATE MODELS
for all 0 ≤ t ≤ T. Notice that (7.5) is always satisfied if Z ⊂ R
+
.
Sufficient for the existence and uniqueness is Lipschitz continuity of b(t, r)
and σ(t, r) in r, uniformly in t. If d = 1 then H¨ older continuity of order 1/2
of σ in r, uniformly in t, is enough. A good reference for SDEs is the book
of Karatzas and Shreve [14] on Brownian motion and stochastic calculus.
Condition (7.5) allows us to define the T-bond prices
P(t, T) = E
Q
¸
exp

T
t
r(u) du

[ T
t

.
It turns out that P(t, T) can be written as a function of r(t), t and T. This is
a general property of certain functionals of Markov process, usually referred
to as Feynman–Kac formula. In the following we write
a(t, r) :=
|σ(t, r)|
2
2
for the diffusion term of r(t).
Lemma 7.2.1. Let T > 0 and Φ be a continuous function on Z, and assume
that F = F(t, r) ∈ C
1,2
([0, T]Z) is a solution to the boundary value problem
on [0, T] Z


t
F(t, r) +b(t, r)∂
r
F(t, r) +a(t, r)∂
2
r
F(t, r) −rF(t, r) = 0
F(T, r) = Φ(r).
(7.6)
Then
M(t) = F(t, r(t))e

t
0
r(u) du
, t ∈ [0, T],
is a local martingale. If in addition either
1. ∂
r
F(t, r(t))e

t
0
r(u) du
σ(t, r(t)) ∈ L
2
[0, T], or
2. M is uniformly bounded,
then M is a true martingale, and
F(t, r(t)) = E
Q
¸
exp

T
t
r(u) du

Φ(r(T)) [ T
t

, t ≤ T. (7.7)
7.2. DIFFUSION SHORT RATE MODELS 81
Proof. We can apply Itˆ o’s formula to M and obtain
dM(t) =


t
F(t, r(t)) +b(t, r(t))∂
r
F(t, r(t))
+a(t, r)∂
2
r
F(t, r(t)) −r(t)F(t, r(t))

e

t
0
r(u) du
dt
+∂
r
F(t, r(t))e

t
0
r(u) du
σ(t, r(t)) dW(t)
= ∂
r
F(t, r(t))e

t
0
r(u) du
σ(t, r(t)) dW(t).
Hence M is a local martingale.
It is now clear that either Condition 1 or 2 imply that M is a true mar-
tingale. Since
M(T) = Φ(r(T))e

T
0
r(u) du
we get
F(t, r(t))e

t
0
r(u) du
= M(t) = E
Q
¸
exp

T
0
r(u) du

Φ(r(T)) [ T
t

.
Multiplying with e

t
0
r(u) du
yields the claim.
We call (7.6) the term structure equation for Φ. Its solution F gives the
price of the T-claim Φ(r(T)). In particular, for Φ ≡ 1 we get the T-bond
price P(t, T) as a function of t, r(t) (and T)
P(t, T) = F(t, r(t); T).
Remark 7.2.2. Strictly speaking, we have only shown that if a smooth solu-
tion F of (7.6) exists and satisfies some additional properties (Condition 1
or 2) then the time t price of the claim Φ(r(T)) (which is the right hand side
of (7.7)) equals F(t, r(t)). One can also show the converse that the expecta-
tion on the right hand side of (7.7) conditional on r(t) = r can be written as
F(t, r) where F solves the term structure equation (7.6) but usually only in a
weak sense, which in particular means that F may not be in C
1,2
([0, T] Z).
This is general Markov theory and we will not prove this here.
In any case, we have found a pricing algorithm. Is it computationally
efficient? Solving PDEs numerically in more than three dimensions causes
difficulties. PDEs in less than three space dimensions are numerically feasi-
ble, and the dimension of Z is one. The nuisance is that we have to solve a
82 CHAPTER 7. SHORT RATE MODELS
PDE for every single zero-coupon bond price function F(, ; T), T > 0. From
that we might want to derive the yield or even forward curve. If we do not
impose further structural assumptions we may run into regularity problems.
Hence
short rate models that admit closed form solutions to the term
structure equation (7.6), at least for Φ ≡ 1, are favorable.
7.2.1 Examples
This is a (far from complete) list of the most popular short rate models. For
all examples we have d = 1. If not otherwise stated, the parameters are
real-valued.
1. Vasicek (1977): Z = R,
dr(t) = (b +βr(t)) dt +σ dW(t),
2. Cox–Ingersoll–Ross (CIR, 1985): Z = R
+
, b ≥ 0,
dr(t) = (b +βr(t)) dt +σ

r(t) dW(t),
3. Dothan (1978): Z = R
+
,
dr(t) = βr(t) dt +σr(t) dW(t),
4. Black–Derman–Toy (1990): Z = R
+
,
dr(t) = β(t)r(t) dt +σ(t)r(t) dW(t),
5. Black–Karasinski (1991): Z = R
+
, (t) = log r(t),
d(t) = (b(t) +β(t)(t)) dt +σ(t) dW(t),
6. Ho–Lee (1986): Z = R,
dr(t) = b(t) dt +σ dW(t),
7. Hull–White (extended Vasicek, 1990): Z = R,
dr(t) = (b(t) +β(t)r(t)) dt +σ(t) dW(t),
8. Hull–White (extended CIR, 1990): Z = R
+
, b(t) ≥ 0,
dr(t) = (b(t) +β(t)r(t)) dt +σ(t)

r(t) dW(t).
7.3. INVERTING THE YIELD CURVE 83
7.3 Inverting the Yield Curve
Once the short rate model is chosen, the initial term structure
T →P(0, T) = F(0, r(0); T)
and hence the initial yield and forward curve are fully specified by the term
structure equation (7.6).
Conversely, one may want to invert the term structure equation (7.6) to
match a given initial yield curve. Say we have chosen the Vasicek model.
Then the implied T-bond price is a function of the current short rate level
and the three model parameters b, β and σ
P(0, T) = F(0, r(0); T, b, β, σ).
But F(0, r(0); T, b, β, σ) is just a parametrized curve family with three degrees
of freedom. It turns out that it is often too restrictive and will provide a poor
fit of the current data in terms of accuracy (least squares criterion).
Therefore the class of time-inhomogeneous short rate models (such as the
Hull–White extensions) was introduced. By letting the parameters depend on
time one gains infinite degree of freedom and hence a perfect fit of any given
curve. Usually, the functions b(t) etc are fully determined by the empirical
initial yield curve.
7.4 Affine Term Structures
Short rate models that admit closed form expressions for the implied bond
prices F(t, r; T) are favorable.
The most tractable models are those where bond prices are of the form
F(t, r; T) = exp(−A(t, T) −B(t, T)r),
for some smooth functions A and B. Such models are said to provide an
affine term structure (ATS). Notice that F(T, r; T) = 1 implies
A(T, T) = B(T, T) = 0.
The nice thing about ATS models is that they can be completely character-
ized.
84 CHAPTER 7. SHORT RATE MODELS
Proposition 7.4.1. The short rate model (7.4) provides an ATS only if its
diffusion and drift terms are of the form
a(t, r) = a(t) +α(t)r and b(t, r) = b(t) +β(t)r, (7.8)
for some continuous functions a, α, b, β. The functions A and B in turn
satisfy the system

t
A(t, T) = a(t)B
2
(t, T) −b(t)B(t, T), A(T, T) = 0, (7.9)

t
B(t, T) = α(t)B
2
(t, T) −β(t)B(t, T) −1, B(T, T) = 0. (7.10)
Proof. We insert F(t, r; T) = exp(−A(t, T) −B(t, T)r) in the term structure
equation (7.6) and obtain
a(t, r)B
2
(t, T) −b(t, r)B(t, T) = ∂
t
A(t, T) + (∂
t
B(t, T) + 1)r. (7.11)
The functions B(t, ) and B
2
(t, ) are linearly independent since otherwise
B(t, ) ≡ B(t, t) = 0, which trivially would lead to be above results with
a(t) = α(t) ≡ 0. Hence we can find T
1
> T
2
> t such that the matrix

B
2
(t, T
1
) −B(t, T
1
)
B
2
(t, T
2
) −B(t, T
2
)

is invertible. Hence we can solve (7.11) for a(t, r) and b(t, r), which yields
(7.8). Replace a(t, r) and b(t, r) by (7.8), so the left hand side of (7.11) reads
a(t)B
2
(t, T) −b(t)B(t, T) +

α(t)B
2
(t, T) −β(t)B(t, T)

r.
Terms containing r must match. This proves the claim.
The functions a, α, b, β in (7.8) can be further specified. They have to be
such that a(t, r) ≥ 0 and r(t) does not leave the state space Z. In fact, it can
be shown that every ATS model can be transformed via affine transformation
into one of the two cases
1. Z = R: necessarily α(t) = 0 and a(t) ≥ 0, and b, β are arbitrary. This
is the (Hull–White extension of the) Vasicek model.
2. Z = R
+
: necessarily a(t) = 0, α(t) ≥ 0 and b(t) ≥ 0 (otherwise the
process would cross zero), and β is arbitrary. This is the (Hull–White
extension of the) CIR model.
Looking at the list in Section 7.2.1 we see that all short rate models except
the Dothan, Black–Derman–Toy and Black–Karasinski models have an ATS.
7.5. SOME STANDARD MODELS 85
7.5 Some Standard Models
We discuss some of the most common short rate models.
→ B[3](Section 17.4), BM[6](Chapter 3)
7.5.1 Vasicek Model
The solution to
dr = (b +βr) dt +σ dW
is explicitly given by (→ exercise)
r(t) = r(0)e
βt
+
b
β

e
βt
−1

+σe
βt

t
0
e
−βs
dW(s).
It follows that r(t) is a Gaussian process with mean
E[r(t)] = r(0)e
βt
+
b
β

e
βt
−1

and variance
V ar[r(t)] = σ
2
e
2βt

t
0
e
−2βs
ds =
σ
2

e
2βt
−1

.
Hence
Q[r(t) < 0] > 0,
which is not satisfactory (although this probability is usually very small).
Vasicek assumed the market price of risk to be constant, so that also the
objective P-dynamics of r(t) is of the above form.
If β < 0 then r(t) is mean-reverting with mean reversion level b/[β[, see
Figure 7.1, and r(t) converges to a Gaussian random variable with mean
b/[β[ and variance σ
2
/(2[β[), for t →∞.
Equations (7.9)–(7.10) become

t
A(t, T) =
σ
2
2
B
2
(t, T) −bB(t, T), A(T, T) = 0,

t
B(t, T) = −βB(t, T) −1, B(T, T) = 0.
The explicit solution is
B(t, T) =
1
β

e
β(T−t)
−1

86 CHAPTER 7. SHORT RATE MODELS
Figure 7.1: Vasicek short rate process for β = −0.86, b/[β[ = 0.09 (mean
reversion level), σ = 0.0148 and r(0) = 0.08.
50 100 150 200 250 300 350
Time in Months
0.07
0.08
0.09
0.1
0.11
0.12
Short Rates
and A is given as ordinary integral
A(t, T) = A(T, T) −

T
t

s
A(s, T) ds
= −
σ
2
2

T
t
B
2
(s, T) ds +b

T
t
B(s, T) ds
=
σ
2

4e
β(T−t)
−e
2β(T−t)
−2β(T −t) −3


3
+b
e
β(T−t)
−1 −β(T −t)
β
2
.
We recall that zero-coupon bond prices are given in closed form by
P(t, T) = exp (−A(t, T) −B(t, T)r(t)) .
It is possible to derive closed form expression also for bond options (see
Section 7.6).
7.5.2 Cox–Ingersoll–Ross Model
It is worth to mention that, for b ≥ 0,
dr(t) = (b +βr(t)) dt +σ

r(t) dW(t), r(0) ≥ 0,
7.5. SOME STANDARD MODELS 87
has a unique strong solution r ≥ 0, for every r(0) ≥ 0. This also holds when
the coefficients depend continuously on t, as it is the case for the Hull–White
extension. Even more, if b ≥ σ
2
/2 then r > 0 whenever r(0) > 0.
The ATS equation (7.10) now becomes non-linear

t
B(t, T) =
σ
2
2
B
2
(t, T) −βB(t, T) −1, B(T, T) = 0.
This is called a Riccati equation. It is good news that the explicit solution is
known
B(t, T) =
2

e
γ(T−t)
−1

(γ −β) (e
γ(T−t)
−1) + 2γ
where γ :=

β
2
+ 2σ
2
. Integration yields
A(t, T) = −
2b
σ
2
log

2γe
(γ−β)(T−t)/2
(γ −β) (e
γ(T−t)
−1) + 2γ

.
Hence also in the CIR model we have closed form expressions for the bond
prices. Moreover, it can be shown that also bond option prices are explicit(!)
Together with the fact that it yields positive interest rates, this is mainly the
reason why the CIR model is so popular.
7.5.3 Dothan Model
Dothan (78) starts from a drift-less geometric Brownian motion under the
objective probability measure P
dr(t) = σr(t) dW
P
(t).
The market price of risk is chosen to be constant, which yields
dr(t) = βr(t) dt +σr(t) dW(t)
as Q-dynamics. This is easily integrated
r(t) = r(s) exp

β −σ
2
/2

(t −s) +σ(W(t) −W(s))

, s ≤ t.
Thus the T
s
-conditional distribution of r(t) is lognormal with mean and
variance (→ exercise)
E[r(t) [ T
s
] = r(s)e
β(t−s)
V ar[r(t) [ T
s
] = r
2
(s)e
2β(t−s)

e
σ
2
(t−s)
−1

.
88 CHAPTER 7. SHORT RATE MODELS
The Dothan and all lognormal short rate models (Black–Derman–Toy and
Black–Karasinski) yield positive interest rates. But no closed form expres-
sions for bond prices or options are available (with one exception: Dothan
admits an “semi-explicit” expression for the bond prices, see BM[6]).
A major drawback of lognormal models is the explosion of the bank ac-
count. Let ∆t be small, then
E[B(∆t)] = E
¸
exp

∆t
0
r(s) ds

≈ E
¸
exp

r(0) +r(∆t)
2
∆t

.
We face an expectation of the type
E[exp(exp(Y ))]
where Y is Gaussian distributed. But such an expectation is infinite. This
means that in arbitrarily small time the bank account growths to infinity in
average. Similarly, one shows that the price of a Eurodollar future is infinite
for all lognormal models.
The idea of lognormal rates is taken up later by Sandmann and Son-
dermann (1997) and many others, which finally led to the so called market
models with lognormal LIBOR or swap rates.
7.5.4 Ho–Lee Model
For the Ho–Lee model
dr(t) = b(t) dt +σ dW(t)
the ATS equations (7.9)–(7.10) become

t
A(t, T) =
σ
2
2
B
2
(t, T) −b(t)B(t, T), A(T, T) = 0,

t
B(t, T) = −1, B(T, T) = 0.
Hence
B(t, T) = T −t,
A(t, T) = −
σ
2
6
(T −t)
3
+

T
t
b(s)(T −s) ds.
7.5. SOME STANDARD MODELS 89
The forward curve is thus
f(t, T) = ∂
T
A(t, T) +∂
T
B(t, T)r(t) = −
σ
2
2
(T −t)
2
+

T
t
b(s) ds +r(t).
Let f

(0, T) be the observed (estimated) initial forward curve. Then
b(s) = ∂
s
f

(0, s) +σ
2
s.
gives a perfect fit of f

(0, T). Plugging this back into the ATS yields
f(t, T) = f

(0, T) −f

(0, t) +σ
2
t(T −t) +r(t).
We can also integrate this expression to get
P(t, T) = e

T
t
f

(0,s) ds+f

(0,t)(T−t)−
σ
2
2
t(T−t)
2
−(T−t)r(t)
.
It is interesting to see that
r(t) = r(0) +

t
0
b(s) ds +σW(t) = f

(0, t) +
σ
2
t
2
2
+σW(t).
That is, r(t) fluctuates along the modified initial forward curve, and we have
f

(0, t) = E[r(t)] −
σ
2
t
2
2
.
7.5.5 Hull–White Model
The Hull–White (1990) extensions of Vasicek and CIR can be fitted to the
initial yield and volatility curve. However, this flexibility has its price: the
model cannot be handled analytically in general. We therefore restrict ourself
to the following extension of the Vasicek model that was analyzed by Hull
and White 1994
dr(t) = (b(t) +βr(t)) dt +σ dW(t).
In this model we choose the constants β and σ to obtain a nice volatility
structure whereas b(t) is chosen in order to match the initial yield curve.
Equation (7.10) for B(t, T) is just as in the Vasicek model

t
B(t, T) = −βB(t, T) −1, B(T, T) = 0
90 CHAPTER 7. SHORT RATE MODELS
with explicit solution
B(t, T) =
1
β

e
β(T−t)
−1

.
Equation (7.9) for A(t, T) now reads
A(t, T) = −
σ
2
2

T
t
B
2
(s, T) ds +

T
t
b(s)B(s, T) ds
We consider the initial forward curve (notice that ∂
T
B(s, T) = −∂
s
B(s, T))
f

(0, T) = ∂
T
A(0, T) +∂
T
B(0, T)r(0)
=
σ
2
2

T
0

s
B
2
(s, T) ds +

T
0
b(s)∂
T
B(s, T) +∂
T
B(0, T)r(0)
= −
σ
2

2

e
βT
−1

2
. .. .
=:g(T)
+

T
0
b(s)e
β(T−s)
ds +e
βT
r(0)
. .. .
=:φ(T)
.
The function φ satisfies

T
φ(T) = βφ(T) +b(T), φ(0) = r(0).
It follows that
b(T) = ∂
T
φ(T) −βφ(T)
= ∂
T
(f

(0, T) +g(T)) −β(f

(0, T) +g(T)).
Plugging in and performing performing some calculations eventually yields
f(t, T) = f

(0, T) −e
β(T−t)
f

(0, t) −
σ
2

2

e
β(T−t)
−1

e
β(T−t)
−e
β(T+t)

+e
β(T−t)
r(t).
7.6 Option Pricing in Affine Models
We show how to price bond options in the affine framework. The discussion
is informal, we do not worry about integrability conditions. The procedure
has to be carried out rigorously from case to case.
7.6. OPTION PRICING IN AFFINE MODELS 91
Let r(t) be a diffusion short rate model with drift
b(t) +β(t)r,
diffusion term
a(t) +α(t)r
and ATS
P(t, T) = e
−A(t,T)−B(t,T)r(t)
.
Let λ ∈ C, and φ and ψ be given as solutions to

t
φ(t, T, λ) = a(t)ψ
2
(t, T, λ) −b(t)ψ(t, T, λ)
φ(T, T, λ) = 0

t
ψ(t, T, λ) = α(t)ψ
2
(t, T, λ) −β(t)ψ(t, T, λ) −1
ψ(T, T, λ) = λ.
This looks much like the ATS equations (7.9)–(7.10), and indeed, by plugging
the right hand side below in the term structure equation (7.6), one sees that
E

e

T
t
r(s) ds
e
−λr(T)
[ T
t

= e
−φ(t,T,λ)−ψ(t,T,λ)r(t)
.
In fact, we have
φ(t, T, 0) = A(t, T) and ψ(t, T, 0) = B(t, T).
Now let t = 0 (for simplicity only). Since discounted zero-coupon bond prices
are martingales we obtain for T ≤ S (→ exercise)
E

e

S
0
r(s) ds
e
−λr(T)

= E

e

T
0
r(s) ds
e
−A(T,S)−B(T,S)r(T)
e
−λr(T)

= e
−A(T,S)
E

e

T
0
r(s) ds
e
−(λ+B(T,S))r(T)

= e
−A(T,S)−φ(0,T,λ+B(T,S))−ψ(0,T,λ+B(T,S))r(0)
.
But
dQ
S
dQ
=
e

S
0
r(s) ds
P(0, S)
defines an equivalent probability measure Q
S
∼ Q on T
S
, the so called S-
forward measure. Hence we have shown that the (extended) Laplace trans-
form of r(T) with respect to Q
S
is
E
Q
S

e
−λr(T)

= e
A(0,S)−A(T,S)−φ(0,T,λ+B(T,S))+(B(0,S)−ψ(0,T,λ+B(T,S)))r(0)
.
92 CHAPTER 7. SHORT RATE MODELS
By Laplace (or Fourier) inversion, one gets the distribution of r(T) under
Q
S
. In some cases (e.g. Vasicek or CIR) this distribution is explicitly known
(e.g. Gaussian or chi-square). In general, this is done numerically.
We now consider a European call option on a S-bond with expiry date
T < S and strike price K. Its price today (t = 0) is
π = E

e

T
0
r(s) ds

e
−A(T,S)−B(T,S)r(T)
−K

+

.
The payoff can be decomposed according to

e
−A(T,S)−B(T,S)r(T)
−K

+
= e
−A(T,S)−B(T,S)r(T)
1
|r(T)≤r

¦
−K1
|r(T)≤r

¦
where
r

= r

(T, S, K) := −
A(T, S) + log K
B(T, S)
.
Hence
π = E

e

S
0
r(s) ds
1
|r(T)≤r

¦

−KE

e

T
0
r(s) ds
1
|r(T)≤r

¦

= P(0, S)Q
S
[r(T) ≤ r

] −KP(0, T)Q
T
[r(T) ≤ r

].
The pricing of the option boils down to the computation of the probability
of the event ¦r(T) ≤ r

¦ under the S- and T-forward measure.
7.6.1 Example: Vasicek Model (a, b, β const, α = 0).
We obtain (→ exercise)
π = P(0, S)Φ

r


1
(T, S, r(0))

2
(T)

−KP(0, T)Φ

r


1
(T, T, r(0))

2
(T)

where

1
(T, S, r) :=
1
β
2

β

e
βT
(b +βr) −b

−a

2 −e
β(S−T)
−2e
βT
+e
β(S+T)

2
(T) :=
a
β

e
2βT
−1

and Φ(x) is the cumulative standard Gaussian distribution function.
A similar closed form expression is available for the price of a put option,
and hence an explicit price formula for caps. For β = −0.86, b/[β[ = 0.09
7.6. OPTION PRICING IN AFFINE MODELS 93
(mean reversion level), σ = 0.0148 and r(0) = 0.08, as in Figure 7.1, one gets
the ATM cap prices and Black volatilities shown in Table 7.1 and Figure 7.2
(→ exercise). In contrast to Figure 2.1, the Vasicek model cannot produce
humped volatility curves.
Table 7.1: Vasicek ATM cap prices and Black volatilities.
Maturity ATM prices ATM vols
1 0.00215686 0.129734
2 0.00567477 0.106348
3 0.00907115 0.0915455
4 0.0121906 0.0815358
5 0.01503 0.0743607
6 0.017613 0.0689651
7 0.0199647 0.0647515
8 0.0221081 0.0613624
10 0.025847 0.0562337
12 0.028963 0.0525296
15 0.0326962 0.0485755
20 0.0370565 0.0443967
30 0.0416089 0.0402203
Figure 7.2: Vasicek ATM cap Black volatilities.
5 10 15 20 25 30
0.04
0.06
0.08
0.1
0.12
0.14
94 CHAPTER 7. SHORT RATE MODELS
Chapter 8
Heath–Jarrow–Morton (HJM)
Methodology
→ original article by Heath, Jarrow and Morton (HJM, 1992) [9].
95
96 CHAPTER 8. HJM METHODOLOGY
Chapter 9
Forward Measures
We consider the HJM setup (Chapter 8) and directly focus on the (unique)
EMM Q ∼ P under which all discounted bond price processes
P(t, T)
B(t)
, t ∈ [0, T],
are strictly positive martingales.
9.1 T-Bond as Numeraire
Fix T > 0. Since
1
P(0, T)B(T)
> 0 and E
Q
¸
1
P(0, T)B(T)

= 1
we can define an equivalent probability measure Q
T
∼ Q on T
T
by
dQ
T
dQ
=
1
P(0, T)B(T)
.
For t ≤ T we have
dQ
T
dQ
[
Tt
= E
Q
¸
dQ
T
dQ
[ T
t

=
P(t, T)
P(0, T)B(t)
.
This probability measure has already been introduced in Section 7.6. It is
called the T-forward measure.
97
98 CHAPTER 9. FORWARD MEASURES
Lemma 9.1.1. For any S > 0,
P(t, S)
P(t, T)
, t ∈ [0, S ∧ T],
is a Q
T
-martingale.
Proof. Let s ≤ t ≤ S ∧ T. Bayes’ rule gives
E
Q
T
¸
P(t, S)
P(t, T)
[ T
s

=
E
Q

P(t,T)
P(0,T)B(t)
P(t,S)
P(t,T)
[ T
s

P(s,T)
P(0,T)B(s)
=
P(s,S)
B(s)
P(s,T)
B(s)
=
P(s, S)
P(s, T)
.
We thus have an entire collection of EMMs now! Each Q
T
corresponds to
a different numeraire, namely the T-bond. Since Q is related to the risk-free
asset, one usually calls Q the risk neutral measure.
T-forward measures give simpler pricing formulas. Indeed, let X be a
T-claim such that
X
B(T)
∈ L
1
(Q, T
T
). (9.1)
Its fair price at time t ≤ T is then given by
π(t) = E
Q

e

T
t
r(s) ds
X [ T
t

.
To compute π(t) we have to know the joint distribution of exp

T
t
r(s) ds

and X, and integrate with respect to that distribution. Thus we have to
compute a double integral, which in most cases turns out to be rather hard
work. If B(T)/B(t) and X were independent under Q (which is not realistic!
it holds, for instance, if r is deterministic) we would have
π(t) = P(t, T)E
Q
[X [ T
t
] ,
a much nicer formula, since
• we only have to compute the single integral E
Q
[X [ T
t
];
9.2. AN EXPECTATION HYPOTHESIS 99
• the bond price P(t, T) can be observed at time t and does not have to
be computed.
The good news is that the above formula holds — not under Q though, but
under Q
T
:
Proposition 9.1.2. Let X be a T-claim such that (9.1) holds. Then
E
Q
T [[X[] < ∞ (9.2)
and
π(t) = P(t, T)E
Q
T [X [ T
t
] . (9.3)
Proof. Bayes’s rule yields
E
Q
T [[X[] = E
Q
¸
[X[
P(0, T)B(T)

< ∞ (by (9.1)),
whence (9.2). And
π(t) = P(0, T)B(t)E
Q
¸
X
P(0, T)B(T)
[ T
t

= P(0, T)B(t)
P(t, T)
P(0, T)B(t)
E
Q
T [X [ T
t
]
= P(t, T)E
Q
T [X [ T
t
] ,
which proves (9.3).
9.2 An Expectation Hypothesis
Under the forward measure the expectation hypothesis holds. That is, the
expression of the forward rates f(t, T) as conditional expectation of the future
short rate r(T).
To see that, we write W for the driving Q-Brownian motion. The forward
rates then follow the dynamics
f(t, T) = f(0, T) +

t
0

σ(s, T)

T
s
σ(s, u) du

ds +

t
0
σ(s, T) dW(s).
(9.4)
100 CHAPTER 9. FORWARD MEASURES
The Q-dynamics of the discounted bond price process is
P(t, T)
B(t)
= P(0, T) +

t
0
P(s, T)
B(s)

T
s
σ(s, u) du

dW(s). (9.5)
This equation has a unique solution
P(t, T)
B(t)
= P(0, T)c
t

T

σ(, u) du

W

.
We thus have
dQ
T
dQ
[
Tt
= c
t

T

σ(, u) du

W

. (9.6)
Girsanov’s theorem applies and
W
T
(t) = W(t) +

t
0

T
s
σ(s, u) du

ds, t ∈ [0, T],
is a Q
T
-Brownian motion. Equation (9.4) now reads
f(t, T) = f(0, T) +

t
0
σ(s, T) dW
T
(s).
Hence, if
E
Q
T
¸
T
0
|σ(s, T)|
2
ds

< ∞
then
(f(t, T))
t∈[0,T]
is a Q
T
-martingale.
Summarizing we have thus proved
Lemma 9.2.1. Under the above assumptions, the expectation hypothesis
holds under the forward measures
f(t, T) = E
Q
T [r(T) [ T
t
] .
9.3. OPTION PRICING IN GAUSSIAN HJM MODELS 101
9.3 Option Pricing in Gaussian HJM Models
We consider a European call option on an S-bond with expiry date T < S
and strike price K. Its price at time t = 0 (for simplicity only) is
π = E
Q

e

T
0
r(s) ds
(P(T, S) −K)
+

.
We proceed as in Section 7.6 and decompose
π = E
Q

B(T)
−1
P(T, S) 1(P(T, S) ≥ K)

−KE
Q

B(T)
−1
1(P(T, S) ≥ K)

= P(0, S)Q
S
[P(T, S) ≥ K] −KP(0, T)Q
T
[P(T, S) ≥ K] .
This option pricing formula holds in general.
We already know that
dP(t, T)
P(t, T)
= r(t) dt +v(t, T) dW(t)
and hence
P(t, T) = P(0, T) exp
¸
t
0
v(s, T) dW(s) +

t
0

r(s) −
1
2
|v(s, T)|
2

ds

where
v(t, T) := −

T
t
σ(t, u) du. (9.7)
We also know that

P(t,T)
P(t,S)

t∈[0,T]
is a Q
S
-martingale and

P(t,S)
P(t,T)

t∈[0,T]
is a
Q
T
-martingale. In fact (→ exercise)
P(t, T)
P(t, S)
=
P(0, T)
P(0, S)
exp
¸
t
0
σ
T,S
(s) dW(s) −
1
2

t
0

|v(s, T)|
2
−|v(s, S)|
2

ds

=
P(0, T)
P(0, S)
exp
¸
t
0
σ
T,S
(s) dW
S
(s) −
1
2

t
0

T,S
(s)|
2
ds

where
σ
T,S
(s) := v(s, T) −v(s, S) =

S
T
σ(s, u) du, (9.8)
102 CHAPTER 9. FORWARD MEASURES
and
P(t, S)
P(t, T)
=
P(0, S)
P(0, T)
exp
¸

t
0
σ
T,S
(s) dW(s) −
1
2

t
0

|v(s, S)|
2
−|v(s, T)|
2

ds

=
P(0, S)
P(0, T)
exp
¸

t
0
σ
T,S
(s) dW
T
(s) −
1
2

t
0

T,S
(s)|
2
ds

.
Now observe that
Q
S
[P(T, S) ≥ K] = Q
S
¸
P(T, T)
P(T, S)

1
K

Q
T
[P(T, S) ≥ K] = Q
T
¸
P(T, S)
P(T, T)
≥ K

.
This suggests to look at those models for which σ
T,S
is deterministic, and
hence
P(T,T)
P(T,S)
and
P(T,S)
P(T,T)
are log-normally distributed under the respective
forward measures.
We thus assume that σ(t, T) = (σ
1
(t, T), . . . , σ
d
(t, T)) are determinis-
tic functions of t and T, and hence forward rates f(t, T) are Gaussian dis-
tributed.
We obtain the following closed form option price formula.
Proposition 9.3.1. Under the above Gaussian assumption, the option price
is
π = P(0, S)Φ[d
1
] −KP(0, T)Φ[d
2
],
where
d
1,2
=
log

P(0,S)
KP(0,T)

±
1
2

T
0

T,S
(s)|
2
ds

T
0

T,S
(s)|
2
ds
,
σ
T,S
(s) is given in (9.8) and Φ is the standard Gaussian CDF.
Proof. It is enough to observe that
log
P(T,T)
P(T,S)
−log
P(0,T)
P(0,S)
+
1
2

T
0

T,S
(s)|
2
ds

T
0

T,S
(s)|
2
ds
9.3. OPTION PRICING IN GAUSSIAN HJM MODELS 103
and
log
P(T,S)
P(T,T)
−log
P(0,S)
P(0,T)
+
1
2

T
0

T,S
(s)|
2
ds

T
0

T,S
(s)|
2
ds
are standard Gaussian distributed under Q
S
and Q
T
, respectively.
Of course, the Vasicek option price formula from Section 7.6.1 can now
be obtained as a corollary of Proposition 9.3.1 (→ exercise).
104 CHAPTER 9. FORWARD MEASURES
Chapter 10
Forwards and Futures
→ B[3](Chapter 20), or Hull (2002) [10]
We discuss two common types of term contracts: forwards, which are
mainly traded OTC, and futures, which are actively traded on many ex-
changes.
The underlying is in both cases a T-claim \, for some fixed future date T.
This can be an exchange rate, an interest rate, a commodity such as copper,
any traded or non-traded asset, an index, etc.
10.1 Forward Contracts
A forward contract on \, contracted at t, with time of delivery T > t, and
with the forward price f(t; T, \) is defined by the following payment scheme:
• at T, the holder of the contract (long position) pays f(t; T, \) and
receives \ from the underwriter (short position);
• at t, the forward price is chosen such that the present value of the
forward contract is zero, thus
E
Q

e

T
t
r(s) ds
(\ −f(t; T, \)) [ T
t

= 0.
This is equivalent to
f(t; T, \) =
1
P(t, T)
E
Q

e

T
t
r(s) ds
\ [ T
t

= E
Q
T [\ [ T
t
] .
105
106 CHAPTER 10. FORWARDS AND FUTURES
Examples The forward price at t of
1. a dollar delivered at T is 1;
2. an S-bond delivered at T ≤ S is
P(t,S)
P(t,T)
;
3. any traded asset S delivered at T is
S(t)
P(t,T)
.
The forward price f(s; T, \) has to be distinguished from the (spot) price
at time s of the forward contract entered at time t ≤ s, which is
E
Q

e

T
s
r(u) du
(\ −f(t; T, \)) [ T
s

= E
Q

e

T
s
r(u) du
\ [ T
s

−P(t, T)f(t; T, \).
10.2 Futures Contracts
A futures contract on \ with time of delivery T is defined as follows:
• at every t ≤ T, there is a market quoted futures price F(t; T, \), which
makes the futures contract on \, if entered at t, equal to zero;
• at T, the holder of the contract (long position) pays F(T; T, \) and
receives \ from the underwriter (short position);
• during any time interval (s, t] the holder of the contract receives (or
pays, if negative) the amount F(t; T, \) − F(s; T, \) (this is called
marking to market).
So there is a continuous cash-flow between the two parties of a futures con-
tract. They are required to keep a certain amount of money as a safety
margin.
The volumes in which futures are traded are huge. One of the reasons
for this is that in many markets it is difficult to trade (hedge) directly in the
underlying object. This might be an index which includes many different
(illiquid) instruments, or a commodity such as copper, gas or electricity,
etc. Holding a (short position in a) futures does not force you to physically
deliver the underlying object (if you exit the contract before delivery date),
and selling short makes it possible to hedge against the underlying.
10.2. FUTURES CONTRACTS 107
Suppose \ ∈ L
1
(Q). Then the futures price process is given by the
Q-martingale
F(t; T, \) = E
Q
[\ [ T
t
] . (10.1)
Often, this is just how futures prices are defined. We now give a heuristic
argument for (10.1) based on the above characterization of a futures contract.
First, our model economy is driven by Brownian motion and changes in
a continuous way. Hence there is no reason to believe that futures prices
evolve discontinuously, and we may assume that
F(t) = F(t; T, \) is a continuous semimartingale (or Itˆ o process).
Now suppose we enter the futures contract at time t < T. We face a con-
tinuum of cashflows in the interval (t, T]. Indeed, let t = t
0
< < t
N
= t
be a partition of [t, T]. The present value of the corresponding cashflows
F(t
i
) −F(t
i−1
) at t
i
, i = 1, . . . , N, is given by E
Q
[Σ [ T
t
] where
Σ :=
N
¸
i=1
1
B(t
i
)
(F(t
i
) −F(t
i−1
)) .
But the futures contract has present value zero, hence
E
Q
[Σ [ T
t
] = 0.
This has to hold for any partition (t
i
). We can rewrite Σ as
N
¸
i=1
1
B(t
i−1
)
(F(t
i
) −F(t
i−1
)) +
N
¸
i=1

1
B(t
i
)

1
B(t
i−1
)

(F(t
i
) −F(t
i−1
)) .
If we let the partition become finer and finer this expression converges in
probability towards

T
t
1
B(s)
dF(s) +

T
t
d

1
B
, F

s
=

T
t
1
B(s)
dF(s),
since the quadratic variation of 1/B (finite variation) and F (continuous) is
zero. Under the appropriate integrability assumptions (uniform integrability)
we conclude that
E
Q
¸
T
t
1
B(s)
dF(s) [ T
t

= 0,
108 CHAPTER 10. FORWARDS AND FUTURES
and that
M(t) =

t
0
1
B(s)
dF(s) = E
Q
¸
T
0
1
B(s)
dF(s) [ T
t

, t ∈ [0, T],
is a Q-martingale. If, moreover
E
Q
¸
T
0
1
B(s)
2
d'M, M`
s

= E
Q
['F, F`
T
] < ∞
then
F(t) =

t
0
1
B(s)
dM(s), t ∈ [0, T],
is a Q-martingale, which implies (10.1).
10.3 Interest Rate Futures
→ Z[27](Section 5.4)
Interest rate futures contracts may be divided into futures on short term
instruments and futures on coupon bonds. We only consider an example
from the first group.
Eurodollars are deposits of US dollars in institutions outside of the US.
LIBOR is the interbank rate of interest for Eurodollar loans. The Eurodollar
futures contract is tied to the LIBOR. It was introduced by the International
Money Market (IMM) of the Chicago Mercantile Exchange (CME) in 1981,
and is designed to protect its owner from fluctuations in the 3-months (=1/4
years) LIBOR. The maturity (delivery) months are March, June, September
and December.
Fix a maturity date T and let L(T) denote the 3-months LIBOR for the
period [T, T + 1/4], prevailing at T. The market quote of the Eurodollar
futures contract on L(T) at time t ≤ T is
1 −L
F
(t, T) [100 per cent]
where L
F
(t, T) is the corresponding futures rate (compare with the example
in Section 4.2.2). As t tends to T, L
F
(t, T) tends to L(T). The futures price,
used for the marking to market, is defined by
F(t; T, L(T)) = 1 −
1
4
L
F
(t, T) [Mio. dollars].
10.4. FORWARD VS. FUTURES IN A GAUSSIAN SETUP 109
Consequently, a change of 1 basis point (0.01%) in the futures rate L
F
(t, T)
leads to a cashflow of
10
6
10
−4

1
4
= 25 [dollars].
We also see that the final price F(T; T, L(T)) = 1 −
1
4
L(T) = \ is not
P(T, T +1/4) = 1 −
1
4
L(T)P(T, T +1/4) as one might suppose. In fact, the
underlying \ is a synthetic value. At maturity there is no physical delivery.
Instead, settlement is made in cash.
On the other hand, since
1 −
1
4
L
F
(t, T) = F(t; T, L(T))
= E
Q
[F(T; T, L(T)) [ T
t
] = 1 −
1
4
E
Q
[L(T) [ T
t
] ,
we obtain an explicit formula for the futures rate
L
F
(t, T) = E
Q
[L(T) [ T
t
] .
10.4 Forward vs. Futures in a Gaussian Setup
Let S be the price process of a traded asset. Hence the Q-dynamics of S is
of the form
dS(t)
S(t)
= r(t) dt +ρ(t) dW(t),
for some volatility process ρ. Fix a delivery date T. The forward and futures
prices of S for delivery at T are
f(t; T, S(T)) =
S(t)
P(t, T)
, F(t; T, S(T)) = E
Q
[S(T) [ T
t
].
Under Gaussian assumption we can establish the relationship between the
two prices.
Proposition 10.4.1. Suppose ρ(t) and v(t, T) are deterministic functions
in t, where
v(t, T) = −

T
t
σ(t, u) du
110 CHAPTER 10. FORWARDS AND FUTURES
is the volatility of the T-bond (see (9.7)). Then
F(t; T, S(T)) = f(t; T, S(T)) exp

T
t
(v(s, T) −ρ(s)) v(s, T) ds

for t ≤ T.
Hence, if the instantaneous correlation of dS(t) and dP(t, T) is negative
d'S, P(, T)`
t
dt
= S(t)P(t, T)ρ(t) v(t, T) ≤ 0
then the futures price dominates the forward price.
Proof. Write µ(s) := v(s, T) −ρ(s). It is clear that
f(t; T, S(T)) =
S(0)
P(0, T)
exp

t
0
µ(s) dW(s) −
1
2

t
0
|µ(s)|
2
ds

exp

t
0
µ(s) v(s, T) ds

,
and hence
f(T; T, S(T)) = f(t; T, S(T)) exp

T
t
µ(s) dW(s) −
1
2

T
t
|µ(s)|
2
ds

exp

T
t
µ(s) v(s, T) ds

.
By assumption µ(s) is deterministic. Consequently,
E
Q
¸
exp

T
t
µ(s) dW(s) −
1
2

T
t
|µ(s)|
2
ds

[ T
t

= 1
and
F(t; T, S(T)) = E
Q
[f(T; T, S(T)) [ T
t
]
= f(t; T, S(T)) exp

T
t
µ(s) v(s, T) ds

,
as desired.
10.4. FORWARD VS. FUTURES IN A GAUSSIAN SETUP 111
Similarly, one can show (→ exercise)
Lemma 10.4.2. In a Gaussian HJM framework (σ(t, T) deterministic) we
have the following relations (convexity adjustments) between instantaneous
and simple futures and forward rates
f(t, T) = E
Q
[r(T) [ T
t
] −

T
t

σ(s, T)

T
s
σ(s, u) du

ds,
F(t; T, S) = E
Q
[F(T, S) [ T
t
]

P(t, T)
(S −T)P(t, S)

e

T
t
(

S
T
σ(s,v) dv

S
s
σ(s,u) du)ds
−1

for t ≤ T < S.
Hence, if
σ(s, v) σ(s, u) ≥ 0 for all s ≤ min(u, v)
then futures rates are always greater than the corresponding forward rates.
112 CHAPTER 10. FORWARDS AND FUTURES
Chapter 11
Multi-Factor Models
We have seen that every time-homogeneous diffusion short rate model r(t)
induces forward rates of the form
f(t, T) = H(T −t, r(t)),
for some deterministic function H. This a one-factor model, since the driving
(Markovian) factor, r(t), is one-dimensional. This is too restrictive from two
points of view:
• statistically: the evolution of the entire yield curve is explained by
a single variable. The infinitesimal increments of all bond prices are
perfectly correlated
d'P(, T), P(, S)`
t

d'P(, T), P(, T)`
t

d'P(, S), P(, S)`
t
=

T
t
σ(t, u)du

S
t
σ(t, u)du

T
t
σ(t, u)du

S
t
σ(t, u)du
= 1.
• analytically: the family of attainable forward curves
H = ¦H(, r) [ r ∈ R¦
is only one-dimensional.
To gain more flexibility, we now allow for multiple factors. Fix m ≥ 1
and a closed set Z ⊂ R
m
(state space). A (m-)factor model is an interest
rate model of the form
f(t, T) = H(T −t, Z(t))
113
114 CHAPTER 11. MULTI-FACTOR MODELS
where H is a deterministic function and Z (state process) is a Z-valued
diffusion process,
dZ(t) = b(Z(t)) dt +ρ(Z(t)) dW(t)
Z(0) = z
0
.
Here W is a d-dimensional Brownian motion defined on a filtered probability
space (Ω, T, (T
t
), Q), satisfying the usual conditions. We assume that
(A1) H ∈ C
1,2
(R
+
Z);
(A2) b : Z →R
m
and ρ : Z →R
md
are continuous functions;
(A3) the above SDE has a unique Z-valued solution Z = Z
z
0
, for every
z
0
∈ Z;
(A4) Q is the risk neutral local martingale measure for the induced bond
prices
P(t, T) = Π(T −t, Z
z
0
(t)),
for all z
0
∈ Z, where
Π(x, z) := exp

x
0
H(s, z) ds

.
Notice that the short rates are now given by r(t) = H(0, Z(t)). Hence the
assumption (A4) is equivalent to
(A4’)

Π(T −t, Z
z
0
(t))
e

t
0
H(0,Z
z
0(s)) ds

t∈[0,T]
is a Q-local martingale, for all z
0
∈ Z.
Time-inhomogeneous models are included in the above setup. Simply set
Z
1
(t) = t (that is, b
1
≡ 1 and ρ
1j
≡ 0 for j = 1, . . . , d).
11.1. NO-ARBITRAGE CONDITION 115
11.1 No-Arbitrage Condition
Since the function (x, z) → H(x, z) is in C
1,2
(R
+
Z) we can apply Itˆ o’s
formula and obtain
df(t, T) =

−∂
x
H(T −t, Z(t)) +
m
¸
i=1
b
i
(Z(t))∂
z
i
H(T −t, Z(t))
+
1
2
m
¸
i,j=1
a
ij
(Z(t))∂
z
i

z
j
H(T −t, Z(t))

dt
+
m
¸
i=1
d
¸
j=1

z
i
H(T −t, Z(t))ρ
ij
(Z(t)) dW
j
(t),
where
a(z) := ρ(z)ρ
T
(z). (11.1)
Hence the induced forward rate model is of the HJM type with
σ
j
(t, T) =
m
¸
i=1

z
i
H(T −t, Z(t))ρ
ij
(Z(t)), j = 1, . . . , d.
The HJM drift condition now reads
−∂
x
H(T −t, Z(t)) +
m
¸
i=1
b
i
(Z(t))∂
z
i
H(T −t, Z(t))
+
1
2
m
¸
i,j=1
a
ij
(Z(t))∂
z
i

z
j
H(T −t, Z(t))
=
d
¸
j=1
m
¸
k,l=1
ρ
kj
(Z(t))ρ
lj
(Z(t))∂
z
i
H(T −t, Z(t))

T
t

z
i
H(u −t, Z(t)) du
=
m
¸
k,l=1
a
kl
(Z(t))∂
z
i
H(T −t, Z(t))

T
t

z
i
H(u −t, Z(t)) du.
This has to hold a.s. for all t ≤ T and initial points z
0
= Z(0). Letting t →0
we thus get the following result.
116 CHAPTER 11. MULTI-FACTOR MODELS
Proposition 11.1.1 (Consistency Condition). Under the above assump-
tions (A1)–(A3), there is equivalence between (A4) and

x
H(x, z) =
m
¸
i=1
b
i
(z)∂
z
i
H(x, z)
+
m
¸
i,j=1
a
ij
(z)

1
2

z
i

z
j
H(x, z) −∂
z
i
H(x, z)

x
0

z
i
H(u, z) du

(11.2)
for all (x, z) ∈ R
+
Z, where a is defined in (11.1).
Remark 11.1.2. Notice that, by symmetry, the last expression in (11.2) can
be written as
m
¸
i,j=1
a
ij
(z)∂
z
i
H(x, z)

x
0

z
i
H(u, z) du
=
1
2

x
m
¸
i,j=1
a
ij
(z)

x
0

z
i
H(u, z) du

x
0

z
j
H(u, z) du

.
There are two ways to approach equation (11.2). First, one takes b and
ρ (and hence a) as given and looks for a solution H for the PDE (11.2). Or,
one takes H as given (an estimation method for the yield curve) and tries
to find b and a such that (11.2) is satisfied for all (x, z). This is an inverse
problem. It turns out that the latter approach is quite restrictive on possible
choices of b and a.
Proposition 11.1.3. Suppose that the functions

z
i
H(, z) and
1
2

z
i

z
j
H(, z) −∂
z
i
H(, z)

0

z
i
H(u, z) du,
for 1 ≤ i ≤ j ≤ m, are linearly independent for all z in some dense subset
T ⊂ Z. Then b and a are uniquely determined by H.
Proof. Set M = m+m(m + 1)/2, the number of unknown functions b
k
and
a
kl
= a
lk
. Let z ∈ T. Then there exists a sequence 0 ≤ x
1
< < x
M
such
that the M M-matrix with k-th row vector built by

z
i
H(x
k
, z) and
1
2

z
i

z
j
H(x
k
, z) −∂
z
i
H(, z)

x
k
0

z
i
H(u, z) du,
11.2. AFFINE TERM STRUCTURES 117
for 1 ≤ i ≤ j ≤ m, is invertible. Thus, b(z) and a(z) are uniquely determined
by (11.2). This holds for each z ∈ T. By continuity of b and a hence for all
z ∈ Z.
Remark 11.1.4. Suppose that the the parametrized curve family
H = ¦H(, z) [ z ∈ Z¦
is used for daily estimation of the forward curve in terms of the state vari-
able z. Then the above proposition tells us that, under the stated assumption,
any Q-diffusion model Z for z is fully determined by H.
If T
t
= T
W
t
is the Brownian filtration, then the diffusion coefficient, a(z),
of Z is not affected by any Girsanov transformation. Consequently, statistical
calibration is only possible for the drift of the model (or equivalently, for
the market price of risk), since the observations of z are made under the
objective measure P ∼ Q, where dQ/dP is left unspecified by our consistency
considerations.
11.2 Affine Term Structures
We first look at the simplest, namely the affine case:
H(x, z) = g
0
(x) +g
1
(x)z
1
+ g
m
(x)z
m
.
Here the second order z-derivatives vanish, and (11.2) reduces to

x
g
0
(x) +
m
¸
i=1
z
i

x
g
i
(x) =
m
¸
i=1
b
i
(z)g
i
(x) −
1
2

x

m
¸
i,j=1
a
ij
(z)G
i
(x)G
j
(x)

,
(11.3)
where
G
i
(x) :=

x
0
g
i
(u) du.
Integrating (11.3) yields
g
0
(x)−g
0
(0)+
m
¸
i=1
z
i
(g
i
(x)−g
i
(0)) =
m
¸
i=1
b
i
(z)G
i
(x)−
1
2
m
¸
i,j=1
a
ij
(z)G
i
(x)G
j
(x).
(11.4)
118 CHAPTER 11. MULTI-FACTOR MODELS
Now if
G
1
, . . . , G
m
, G
1
G
1
, G
1
G
2
, . . . , G
m
G
m
are linearly independent functions, we can invert and solve the linear equation
(11.4) for b and a. Since the left hand side is affine is z, we obtain that also
b and a are affine
b
i
(z) = b
i
+
m
¸
j=1
β
ij
z
j
a
ij
(z) = a
ij
+
m
¸
k=1
α
k;ij
z
k
,
for some constant vectors and matrices b, β, a and α
k
. Plugging this back
into (11.4) and matching constant terms and terms containing z
k
s we obtain
a system of Riccati equations

x
G
0
(x) = g
0
(0) +
m
¸
i=1
b
i
G
i
(x) −
1
2
m
¸
i,j=1
a
ij
G
i
(x)G
j
(x) (11.5)

x
G
k
(x) = g
k
(0) +
m
¸
i=1
β
ki
G
i
(x) −
1
2
m
¸
i,j=1
α
k;ij
G
i
(x)G
j
(x), (11.6)
with initial conditions G
0
(0) = = G
m
(0) = 0. This extends what we have
found in Section 7.4 for the one-factor case.
Notice that we have the freedom to choose g
0
(0), . . . , g
m
(0), which are
related to the short rates by
r(t) = f(t, t) = g
0
(0) +g
1
(0)Z
1
(t) + +g
m
(0)Z
m
(t).
A typical choice is g
1
(0) = 1 and all the other g
i
(0) = 0, whence Z
1
(t) is the
(non-Markovian) short rate process.
11.3 Polynomial Term Structures
We extend the ATS setup and consider polynomial term structures (PTS)
H(x, z) =
n
¸
[i[=0
g
i
(x) (Z
t
)
i
, (11.7)
11.3. POLYNOMIAL TERM STRUCTURES 119
where we use the multi-index notation i = (i
1
, . . . , i
m
), [i[ = i
1
+ +i
m
and
z
i
= z
i
1
1
z
im
m
. Here n denotes the degree of the PTS; that is, there exists
an index i with [i[ = n and g
i
= 0.
Thus for n = 1 we are back to the ATS case.
For n = 2 we have a quadratic term structure (QTS), which has also been
studied in the literature.
Do we gain something by looking at n = 3 and higher degree PTS models?
The answer is no. In fact, we now shall show the amazing result that n > 2
is not consistent with (11.2).
For µ ∈ ¦1, . . . , n¦ and k ∈ ¦1, . . . , m¦ we write (µ)
k
for the multi-
index with µ at the k-th position and zeros elsewhere. Let i
1
, i
2
, . . . , i
N
be a
numbering of the set of multi-indices
I = ¦i = (i
1
, . . . , i
m
) [ [i[ ≤ n¦, where N := [I[ =
n
¸
[i[=0
1.
As above, we denote the integral of g
i
by
G
i
(x) :=

x
0
g
i
(u) du.
Theorem 11.3.1 (Maximal Degree Problem I). Suppose that G

and
G

G

are linearly independent functions, 1 ≤ µ ≤ ν ≤ N, and that ρ ≡ 0.
Then necessarily n ∈ ¦1, 2¦. Moreover, b(z) and a(z) are polynomials in
z with deg b(z) ≤ 1 in any case (QTS and ATS), and deg a(z) = 0 if n = 2
(QTS) and deg a(z) ≤ 1 if n = 1 (ATS).
Proof. Define the functions
B
i
(z) := b
k
(z)
∂z
i
∂z
k
+
1
2
m
¸
k,l=1
a
kl
(z)

2
z
i
∂z
k
∂z
l
(11.8)
A
ij
(z) = A
ji
(z) :=
1
2
m
¸
k,l=1
a
kl
(z)
∂z
i
∂z
k
∂z
j
∂z
l
. (11.9)
Equation (11.2) can be rewritten
N
¸
µ=1

g

(x) −g

(0)

z

=
N
¸
µ=1
G

(x)B

(z) −
N
¸
µ,ν=1
G

(x)G

(x)A
iµiν
(z).
(11.10)
120 CHAPTER 11. MULTI-FACTOR MODELS
By assumption we can solve this linear equation for B and A, and thus
B
i
(z) and A
ij
(z) are polynomials in z of order less than or equal n. In
particular, we have
B
(1)
k
(z) = b
k
(z),
2A
(1)
k
(1)
l
(z) = a
kl
(z), k, l ∈ ¦1, . . . , m¦, (11.11)
hence b(z) and a(z) are polynomials in z with deg b(z), deg a(z) ≤ n. An
easy calculation shows that
2A
(n)
k
(n)
k
(z) = a
kk
(z)n
2
z
2n−2
k
, k ∈ ¦1, . . . , m¦. (11.12)
We may assume that a
kk
≡ 0, since ρ ≡ 0. But then the right hand side
of (11.12) cannot be a polynomial in z of order less than or equal n unless
n ≤ 2. This proves the first part of the theorem.
If n = 1 there is nothing more to prove. Now let n = 2. Notice that by
definition
deg
µ
a
kl
(z) ≤ (deg
µ
a
kk
(z) + deg
µ
a
ll
(z))/2,
where deg
µ
denotes the degree of dependence on the single component z
µ
.
Equation (11.12) yields deg
k
a
kk
(z) = 0. Hence deg
l
a
kl
(z) ≤ 1. Consider
2A
(1)
k
+(1)
l
,(1)
k
+(1)
l
(z) = a
kk
(z)z
2
l
+ 2a
kl
(z)z
k
z
l
+a
ll
(z)z
2
k
, k, l ∈ ¦1, . . . , m¦.
From the preceding arguments it is now clear that also deg
l
a
kk
(z) = 0, and
hence deg a(z) = 0. We finally have
B
(1)
k
+(1)
l
(z) = b
k
(z)z
l
+b
l
(z)z
k
+a
kl
(z), k, l ∈ ¦1, . . . , m¦,
from which we conclude that deg b(z) ≤ 1.
We can relax the hypothesis on G in Theorem 11.3.1 if from now on we
make the following standing assumptions: Z ⊂ R
m
is a cone, and b and ρ
satisfy a linear growth condition
|b(z)| +|ρ(z)| ≤ C(1 +|z|), ∀z ∈ Z, (11.13)
for some constant C ∈ R
+
.
11.3. POLYNOMIAL TERM STRUCTURES 121
Theorem 11.3.2 (Maximal Degree Problem II). Suppose that
'a(z)v, v` ≥ k(z)|v|
2
, ∀v ∈ R
m
, (11.14)
for some function k : Z →R
+
with
liminf
z∈?,|z|→∞
k(z) > 0. (11.15)
Then necessarily n ∈ ¦1, 2¦.
Conditions (11.14) and (11.15) say that a(z) becomes uniformly elliptic
for |z| large enough.
Proof. We shall make use of the basic inequality
[z
i
[ ≤ |z|
[i[
, ∀z ∈ R
m
. (11.16)
This is immediate, since
[z
i
[
|z|
[i[
=

[z
1
[
|z|

i
1

[z
m
[
|z|

im
≤ 1, ∀z ∈ R
m
` ¦0¦.
Now define
Γ
k
(x, z) :=
N
¸
µ=1
G

(x)
∂z

∂z
k
(11.17)
Λ
kl
(x, z) = Λ
lk
(x, z) :=
N
¸
µ=1
G

(x)

2
z

∂z
k
∂z
l
. (11.18)
Then (11.2) can be rewritten as (integration)
n
¸
[i[=0
(g
i
(x) −g
i
(0)) z
i
=
m
¸
k=1
b
k
(z)Γ
k
(x, z)
+
1
2
m
¸
k,l=1
a
kl
(z) (Λ
kl
(x, z) −Γ
k
(x, z)Γ
l
(x, z)) ,
(11.19)
Suppose now that n > 2. We have from (11.17)
Γ
k
(x, z) =
¸
[i[=n
G
i
(x)i
k
z
i−(1)
k
+ =: P
k
(x, z) + ,
122 CHAPTER 11. MULTI-FACTOR MODELS
where P
k
(x, z) is a homogeneous polynomial in z of order n − 1, and
stands for lower order terms in z. By assumptions there exist x ∈ R
+
and
k ∈ ¦1, . . . , m¦ such that P
k
(x, ) = 0. Choose z

∈ Z`¦0¦ with P
k
(x, z

) = 0
and set z
α
:= αz

, for α > 0. Then we have z
α
∈ Z and
Γ
k
(x, z
α
) = α
n−1
P
k
(x, z

) + ,
where denotes lower order terms in α. Consequently,
lim
α→∞
Γ
k
(x, z
α
)
|z
α
|
n−1
=
P
k
(x, z

)
|z

|
n−1
= 0. (11.20)
Combining (11.14) and (11.15) with (11.20) we conclude that
L := liminf
α→∞
1
|z
α
|
2n−2
'a(z
α
)Γ(x, z
α
), Γ(x, z
α
)`
≥ liminf
α→∞
k(z
α
)
|Γ(x, z
α
)|
2
|z
α
|
2n−2
> 0. (11.21)
On the other hand, by (11.19),
L ≤
n
¸
[i[=0
[g
i
(x) −g
i
(0)[
[z
i
α
[
|z
α
|
2n−2
+
|b(z
α
)|
|z
α
|
|Γ(x, z
α
)|
|z
α
|
2n−3
+
1
2
|a(z
α
)|
|z
α
|
2
|Λ(x, z
α
)|
|z
α
|
2n−4
,
for all α > 0. In view of (11.17), (11.18), (11.13) and (11.16), the right hand
side converges to zero for α → ∞. This contradicts (11.21), hence n ≤ 2.
11.4 Exponential-Polynomial Families
We consider the Nelson–Siegel and Svensson families. For a discussion of
general exponential-polynomial families see [8].
11.4.1 Nelson–Siegel Family
Recall the form of the Nelson–Siegel curves
G
NS
(x, z) = z
1
+ (z
2
+z
3
x)e
−z
4
x
.
11.4. EXPONENTIAL-POLYNOMIAL FAMILIES 123
Proposition 11.4.1. There is no non-trivial diffusion process Z that is con-
sistent with the Nelson–Siegel family. In fact, the unique solution to (11.2)
is
a(z) = 0, b
1
(z) = b
4
(z) = 0, b
2
(z) = z
3
−z
2
z
4
, b
3
(z) = −z
3
z
4
.
The corresponding state process is
Z
1
(t) ≡ z
1
,
Z
2
(t) = (z
2
+z
3
t) e
−z
4
t
,
Z
3
(t) = z
3
e
−z
4
t
,
Z
4
(t) ≡ z
4
,
where Z(0) = (z
1
, . . . , z
4
) denotes the initial point.
Proof. Exercise.
11.4.2 Svensson Family
Here the forward curve is
G
S
(x, z) = z
1
+ (z
2
+z
3
x)e
−z
5
x
+z
4
xe
−z
6
x
.
Proposition 11.4.2. The only non-trivial HJM model that is consistent with
the Svensson family is the Hull–White extended Vasicek short rate model
dr(t) =

z
1
z
5
+z
3
e
−z
5
t
+z
4
z
−2z
5
t
−z
5
r(t)

dt +

z
4
z
5
e
−z
5
t
dW

(t),
where (z
1
, . . . , z
5
) are given by the initial forward curve
f(0, x) = z
1
+ (z
2
+z
3
x)e
−z
5
x
+z
4
xe
−2z
5
x
and W

is some Brownian motion. The form of the corresponding state
process Z is given in the proof below.
Proof. The consistency equation (11.2) becomes
q
1
(x) +q
2
(x)e
−z
5
x
+q
3
(x)e
−z
6
x
+q
4
(x)e
−2z
5
x
+q
5
(x)e
−(z
5
+z
6
)x
+q
6
(x)e
−2z
6
x
= 0, (11.22)
124 CHAPTER 11. MULTI-FACTOR MODELS
for some polynomials q
1
, . . . , q
6
. Indeed, we assume for the moment that
z
5
= z
6
, z
5
+z
6
= 0 and z
i
= 0 for all i = 1, . . . , 6. (11.23)
Then the terms involved in (11.2) are

x
G
S
(x, z) = (−z
2
z
5
+z
3
−z
3
z
5
x)e
−z
5
x
+ (z
4
−z
4
z
6
x)e
−z
6
x
,

z
G
S
(x, z) =

¸
¸
¸
¸
¸
¸
¸
1
e
−z
5
x
xe
−z
5
x
xe
−z
6
x
(−z
2
x −z
3
x
2
)e
−z
5
x
−z
4
x
2
e
−z
6
x

,

z
i

z
j
G
S
(x, z) = 0 for 1 ≤ i, j ≤ 4,

z

z
5
G
S
(x, z) =

¸
¸
¸
¸
¸
¸
¸
0
−xe
−z
5
x
−x
2
e
−z
5
x
0
(z
2
x
2
+z
3
x
3
)e
−z
5
x
0

, ∇
z

z
6
G
S
(x, z) =

¸
¸
¸
¸
¸
¸
¸
0
0
0
−x
2
e
−z
6
x
0
z
4
x
3
e
−z
6
x

,

x
0

z
G
S
(u, z) du =

¸
¸
¸
¸
¸
¸
¸
¸
¸
¸
¸
x

1
z
5
e
−z
5
x
+
1
z
5

x
z
5

1
z
2
5

e
−z
5
x
+
1
z
2
5


x
z
6

1
z
2
6

e
−z
6
x
+
1
z
2
6

z
3
z
5
x
2
+

z
2
z
5
+
2z
3
z
2
5

x +
z
2
z
2
5
+
2z
3
z
3
5

e
−z
5
x

z
2
z
2
5

z
3
z
3
5

z
4
z
6
x
2
+
2z
4
z
2
6
x +
2z
4
z
3
6

e
−z
6
x

z
4
z
3
6

.
Straightforward calculations lead to
q
1
(x) = −a
11
(z)x + ,
q
2
(x) = a
55
(z)
z
2
3
z
5
x
4
+ ,
q
3
(x) = a
66
(z)
z
2
4
z
6
x
4
+ ,
deg q
4
, deg q
5
deg q
6
≤ 3,
11.4. EXPONENTIAL-POLYNOMIAL FAMILIES 125
where stands for lower order terms in x. Because of (11.23) we conclude
that
a
11
(z) = a
55
(z) = a
66
(z) = 0.
But a is a positive semi-definite symmetric matrix. Hence
a
1j
(z) = a
j1
(z) = a
5j
(z) = a
j5
(z) = a
6j
(z) = a
j6
(z) = 0 ∀j = 1 . . . , 6.
Taking this into account, expression (11.22) simplifies considerably. We are
left with
q
1
(x) = b
1
(z),
deg q
2
(x), deg q
3
≤ 1,
q
4
(x) = a
33
(z)
1
z
5
x
2
+ ,
q
5
(x) = a
34
(z)

1
z
5
+
1
z
6

x
2
+ ,
q
6
(x) = a
44
(z)
1
z
6
x
2
+ .
Because of (11.23) we know that the exponents −2z
5
, −(z
5
+ z
6
) and −2z
6
are mutually different. Hence
b
1
(z) = a
3j
(z) = a
j3
(z) = a
4j
(z) = a
j4
(z) = 0 ∀j = 1, . . . 6.
Only a
22
(z) is left as strictly positive candidate among the components of
a(z). The remaining terms are
q
2
(x) = (b
3
(z) +z
3
z
5
)x +b
2
(z) −z
3

a
22
(z)
z
5
+z
2
z
5
,
q
3
(x) = (b
4
(z) +z
4
z
6
)x −z
4
,
q
4
(x) = a
22
(z)
1
z
5
,
while q
1
= q
5
= q
6
= 0.
If 2z
5
= z
6
then also a
22
(z) = 0. If 2z
5
= z
6
then the condition q
3
+q
4
=
q
2
= 0 leads to
a
22
(z) = z
4
z
5
,
b
2
(z) = z
3
+z
4
−2
5
z
2
,
b
3
(z) = −z
5
z
3
,
b
4
(z) = −2z
5
z
4
.
126 CHAPTER 11. MULTI-FACTOR MODELS
We derived the above results under the assumption (11.23). But the set
of z where (11.23) holds is dense Z. By continuity of a(z) and b(z) in z, the
above results thus extend for all z ∈ Z. In particular, all Z
i
’s but Z
2
are
deterministic; Z
1
, Z
5
and Z
6
are even constant.
Thus, since
a(z) = 0 if 2z
5
= z
6
,
we only have a non-trivial process Z if
Z
6
(t) ≡ 2Z
5
(t) ≡ 2Z
5
(0).
In that case we have, writing shortly z
i
= Z
i
(0),
Z
1
(t) ≡ z
1
,
Z
3
(t) = z
3
e
−z
5
t
,
Z
4
(t) = z
4
z
−2z
5
t
and
dZ
2
(t) =

z
3
e
−z
5
t
+z
4
z
−2z
5
t
−z
5
Z
2
(t)

dt +
d
¸
j=1
ρ
2j
(t) dW
j
(t),
where ρ
2j
(t) (not necessarily deterministic) are such that
d
¸
j=1
ρ
2
2j
(t) = a
22
(Z(t)) = z
4
z
5
e
−2z
5
t
.
By L´evy’s characterization theorem we have that
W

(t) :=
d
¸
j=1

t
0
ρ
2j
(s)

z
4
z
5
e
−z
5
s
dW
j
(s)
is a real-valued standard Brownian motion (→ exercise). Hence the corre-
sponding short rate process
r(t) = G
S
(0, Z(t)) = z
1
+Z
2
(t)
satisfies
dr(t) =

z
1
z
5
+z
3
e
−z
5
t
+z
4
z
−2z
5
t
−z
5
r(t)

dt +

z
4
z
5
e
−z
5
t
dW

(t).
Chapter 12
Market Models
Instantaneous forward rates are not always easy to estimate, as we have seen.
One may want to model other rates, such as LIBOR, directly. There has been
some effort in the years after the publication of HJM [9] in 1992 to develop
arbitrage-free models of other than instantaneous, continuously compounded
rates. The breakthrough came 1997 with the publications of Brace–Gatarek–
Musiela [5] (BGM), who succeeded to find a HJM type model inducing log-
normal LIBOR rates, and Jamshidian [12], who developed a framework for
arbitrage-free LIBOR and swap rate models not based on HJM. The principal
idea of both approaches is to chose a different numeraire than the risk-free
account (the latter does not even necessarily have to exist). Both approaches
lead to Black’s formula for either caps (LIBOR models) or swaptions (swap
rate models). Because of this they are usually referred to as “market models”.
To start with we consider the HJM setup, as in Chapter 9. Recall that,
for a fixed δ (typically 1/4 = 3 months), the forward δ-period LIBOR for the
future date T prevailing at time t is the simple forward rate
L(t, T) = F(t; T, T +δ) =
1
δ

P(t, T)
P(t, T +δ)
−1

.
We have seen in Chapter 9 that P(t, T)/P(t, T + δ) is a martingale for the
(T +δ)-forward measure Q
T+δ
. In particular (see (9.8))
d

P(t, T)
P(t, T +δ)

=
P(t, T)
P(t, T +δ)
σ
T,T+δ
(t) dW
T+δ
(t).
127
128 CHAPTER 12. MARKET MODELS
Hence
dL(t, T) =
1
δ
d

P(t, T)
P(t, T +δ)

=
1
δ
P(t, T)
P(t, T +δ)
σ
T,T+δ
(t) dW
T+δ
(t)
=
1
δ
(δL(t, T) + 1)σ
T,T+δ
(t) dW
T+δ
(t).
Now suppose there exists a deterministic R
d
-valued function λ(t, T) such
that
σ
T,T+δ
(t) =
δL(t, T)
δL(t, T) + 1
λ(t, T). (12.1)
Plugging this in the above formula, we get
dL(t, T) = L(t, T)λ(t, T) dW
T+δ
(t),
which is equivalent to
L(t, T) = L(s, T) exp

t
s
λ(u, T) dW
T+δ
(u) −
1
2

t
s
|λ(u, T)|
2
du

,
for s ≤ t ≤ T. Hence the Q
T+δ
-distribution of log L(T, T) conditional on T
t
is Gaussian with mean
log L(t, T) −
1
2

T
t
|λ(s, T)|
2
ds
and variance

T
t
|λ(s, T)|
2
ds.
The time t price of a caplet with reset date T, settlement date T + δ and
strike rate κ is thus
E
Q

e

T+δ
0
r(s) ds
δ(L(T, T) −κ)
+
[ T
t

= P(t, T +δ)E
Q
T+δ

δ(L(T, T) −κ)
+
[ T
t

= δP(t, T +δ) (L(t, T)Φ(d
1
(t, T)) −κΦ(d
2
(t, T))) ,
where
d
1,2
(t, T) :=
log

L(t,T)
κ

±
1
2

T
t
|λ(s, T)|
2
ds

T
t
|λ(s, T)|
2
ds
1
2
,
12.1. MODELS OF FORWARD LIBOR RATES 129
and Φ is the standard Gaussian CDF. This is just Black’s formula for the
caplet price with σ(t)
2
set equal to
1
T −t

T
t
|λ(s, T)|
2
ds,
as introduced in Section 2.6!
We have thus shown that any HJM model satisfying (12.1) yields Black’s
formula for caplet prices. But do such HJM models exist? The answer is yes,
but the construction and proof are not easy. The idea is to rewrite (12.1),
using the definition of σ
T,T+δ
(t), as (→ exercise)

T+δ
T
σ(t, u) du =

1 −e

T+δ
T
f(t,u) du

λ(t, T).
Differentiating in T gives
σ(t, T +δ)
= σ(t, T) + (f(t, T +δ) −f(t, T))e

T+δ
T
f(t,u) du
λ(t, T)
+

1 −e

T+δ
T
f(t,u) du


T
λ(t, T).
This is a recurrence relation that can be solved by forward induction, once
σ(t, ) is determined on [0, δ) (typically, σ(t, T) = 0 for T ∈ [0, δ)). This
gives a complicated dependence of σ on the forward curve. Now it has to be
proved that the corresponding HJM equations for the forward rates have a
unique and well-behaved solution. This all has been carried out by BGM [5],
see also [8, Section 5.6].
12.1 Models of Forward LIBOR Rates
→ MR[19](Chapter 14), Z[27](Section 4.7)
There is a more direct approach to LIBOR models without making ref-
erence to continuously compounded forward and short rates. In a sense,
we place ourselves outside of the HJM framework (although HJM is often
implicitly adopted). Instead of the risk neutral martingale measure we will
work under forward measures; the numeraires accordingly being bond price
processes.
130 CHAPTER 12. MARKET MODELS
12.1.1 Discrete-tenor Case
We fix a finite time horizon T
M
= Mδ, for some M ∈ N, and a probability
space
(Ω, T, (T
t
)
t∈[0,T
M
]
, Q
T
M
),
where T
t
= T
W
T
M
t
is the filtration generated by a d-dimensional Brownian
motion W
T
M
(t), t ∈ [0, T
M
]. The notation already suggests that Q
T
M
will
play the role of the T
M
-forward measure. Write
T
m
:= mδ, m = 0, . . . , M.
We are going to construct a model for the forward LIBOR rates with matu-
rities T
1
, . . . , T
M−1
. We take as given:
• for every m ≤ M − 1, an R
d
-valued, bounded, deterministic function
λ(t, T
m
), t ∈ [0, T
m
], which represents the volatility of L(t, T
m
);
• an initial strictly positive and decreasing discrete term structure
P(0, T
m
), m = 0, . . . , M,
and hence strictly positive initial forward LIBOR rates
L(0, T
m
) =
1
δ

P(0, T
m
)
P(0, T
m+1
)
−1

, m = 0, . . . , M −1.
We proceed by backward induction and postulate first that
dL(t, T
M−1
) = L(t, T
M−1
)λ(t, T
M−1
) dW
T
M
(t), t ∈ [0, T
M−1
],
L(0, T
M−1
) =
1
δ

P(0, T
M−1
)
P(0, T
M
)
−1

which is of course equivalent to
L(t, T
M−1
) =
1
δ

P(0, T
M−1
)
P(0, T
M
)
−1

c
t

λ(, T
M−1
) W
T
M

.
Now define the bounded (why?) R
d
-valued process
σ
T
M−1
,T
M
(t) :=
δL(t, T
M−1
)
δL(t, T
M−1
) + 1
λ(t, T
M−1
), t ∈ [0, T
M−1
],
12.1. MODELS OF FORWARD LIBOR RATES 131
compare with (12.1).
This induces an equivalent probability measure Q
T
M−1
∼ Q
T
M
on T
T
M−1
via
dQ
T
M−1
dQ
T
M
= c
T
M−1

σ
T
M−1
,T
M
W
T
M

,
and by Girsanov’s theorem
W
T
M−1
(t) := W
T
M
(t) −

t
0
σ
T
M−1
,T
M
(s) ds, t ∈ [0, T
M−1
],
is a Q
T
M−1
-Brownian motion.
Hence we can postulate
dL(t, T
M−2
) = L(t, T
M−2
)λ(t, T
M−2
) dW
T
M−1
(t), t ∈ [0, T
M−2
],
L(0, T
M−2
) =
1
δ

P(0, T
M−2
)
P(0, T
M−1
)
−1

,
that is,
L(t, T
M−2
) =
1
δ

P(0, T
M−2
)
P(0, T
M−1
)
−1

c
t

λ(, T
M−2
) W
T
M−1

,
and define the bounded R
d
-valued process
σ
T
M−2
,T
M−1
(t) :=
δL(t, T
M−2
)
δL(t, T
M−2
) + 1
λ(t, T
M−2
), t ∈ [0, T
M−2
],
yielding an equivalent probability measure Q
T
M−2
∼ Q
T
M−1
on T
T
M−2
via
dQ
T
M−2
dQ
T
M−1
= c
T
M−2

σ
T
M−2
,T
M−1
W
T
M−1

,
and the Q
T
M−2
-Brownian motion
W
T
M−2
(t) := W
T
M−1
(t) −

t
0
σ
T
M−2
,T
M−1
(s) ds, t ∈ [0, T
M−2
].
Repeating this procedure leads to a family of log-normal martingales
(L(t, T
m
))
t∈[0,Tm]
under their respective measures Q
Tm
.
132 CHAPTER 12. MARKET MODELS
Bond Prices
What about bond prices? For all m = 1, . . . , M, we then can define the
forward price process
P(t, T
m−1
)
P(t, T
m
)
:= δL(t, T
m−1
) + 1, t ∈ [0, T
m−1
].
Since
d

P(t, T
m−1
)
P(t, T
m
)

= δ dL(t, T
m−1
) = δL(t, T
m−1
)λ(t, T
m−1
) dW
Tm
(t)
=
P(t, T
m−1
)
P(t, T
m
)
σ
T
m−1
,Tm
(t) dW
Tm
(t)
we get that
P(t, T
m−1
)
P(t, T
m
)
=
P(0, T
m−1
)
P(0, T
m
)
c
t

σ
T
m−1
,Tm
W
Tm

, t ∈ [0, T
m−1
],
which is a Q
Tm
-martingale.
From this we can derive, for 0 ≤ i < j ≤ m,
P(T
i
, T
j
) =
j
¸
m=i+1
P(T
i
, T
m
)
P(T
i
, T
m−1
)
=
j
¸
m=i+1
1
δL(T
i
, T
m−1
) + 1
. (12.2)
However, it is not possible to uniquely determine the continuous time dynam-
ics of a bond price P(t, T
m
) in the discrete-tenor model of forward LIBOR
rates. The knowledge of forward LIBOR rates for all maturities T ∈ [0, T
M−1
]
is necessary.
LIBOR Dynamics under Different Measures
We are interested in finding the dynamics of L(t, T
m
) under any of the forward
measures Q
T
k
.
12.1. MODELS OF FORWARD LIBOR RATES 133
Lemma 12.1.1. Let 0 ≤ m ≤ M − 1 and 0 ≤ k ≤ M. Then the dynamics
of L(t, T
m
) under Q
T
k
is given according to the three cases
k < m + 1 :
dL(t, T
m
)
L(t, T
m
)
= λ(t, T
m
)
m
¸
l=k
σ
T
l
,T
l+1
(t) dt +λ(t, T
m
) dW
T
k
(t);
k = m + 1 :
dL(t, T
m
)
L(t, T
m
)
= λ(t, T
m
) dW
T
m+1
(t);
k > m + 1 :
dL(t, T
m
)
L(t, T
m
)
= −λ(t, T
m
)
k−1
¸
l=m+1
σ
T
l
,T
l+1
(t)dt +λ(t, T
m
)dW
T
k
(t),
for t ∈ [0, T
k
∧ T
m
].
Proof. This follows from the equality
W
T
i
(t) = W
T
j
(t) −
j−1
¸
l=i

t
0
σ
T
l
,T
l+1
(s) ds, t ∈ [0, T
i
],
for all 1 ≤ i < j ≤ M.
Derivative Pricing
Here is a useful formula, which can be combined with (12.2).
Lemma 12.1.2. Let X ∈ L
1
(Q
Tm
) be a T
m
-contingent claim, m ≤ M. Then
its price π(t) at t ≤ T
m
is given by
π(t) = P(t, T
m
)E
Q
Tm [X [ T
t
]
= P(t, T
n
)E
Q
Tn
¸
X
P(T
m
, T
n
)
[ T
t

,
for all m < n ≤ M (strictly speaking, this formula makes sense only for
t = T
j
, 0 ≤ j ≤ m, since we know P(t, T
n
) only for such t).
Proof. Notice that
dQ
T
k
dQ
T
k+1
[
Tt
= c
t

σ
T
k
,T
k+1
W
T
k+1

=
P(0, T
k+1
)
P(0, T
k
)
P(t, T
k
)
P(t, T
k+1
)
, t ∈ [0, T
k
].
134 CHAPTER 12. MARKET MODELS
Hence
dQ
Tm
dQ
Tn
[
Tt
=
n−1
¸
k=m
dQ
T
k
dQ
T
k+1
[
Tt
=
n−1
¸
k=m
P(0, T
k+1
)
P(0, T
k
)
P(t, T
k
)
P(t, T
k+1
)
=
P(0, T
n
)
P(0, T
m
)
P(t, T
m
)
P(t, T
n
)
.
Bayes’ rule now yields the assertion, since the first equality was derived in
Proposition 9.1.2 (strictly speaking, we assumed there the existence of a sav-
ings account. But even if there is no risk neutral but only forward measures,
the reasoning in Section 9.1 makes it clear that (9.3) is the arbitrage-free
price of X).
Swaptions
Consider a payer swaption with nominal 1, strike rate K, maturity T
µ
and
underlying tenor T
µ
, T
µ+1
, . . . , T
ν
(T
µ
is the first reset date and T
ν
the ma-
turity of the underlying swap), for some positive integers µ < ν ≤ M. Its
payoff at maturity is
δ

ν−1
¸
m=µ
P(T
µ
, T
m
)(L(T
µ
, T
m
) −K)

+
.
The swaption price at t = 0 (for simplicity) therefore
π(0) = δP(0, T
µ
)E
Q

ν−1
¸
m=µ
P(T
µ
, T
m
)(L(T
µ
, T
m
) −K)

+
¸
¸
.
To compute π(0) we thus need to know the joint distribution of
L(T
µ
, T
µ
), L(T
µ
, T
µ+1
), . . . , L(T
µ
, T
ν−1
)
under the measure Q

. This cannot be done analytically anymore, so one
has to resort to numerical procedures.
We sketch here the Monte Carlo method. Notice that by Lemma 12.1.1,
Itˆ o’s formula and the definition of σ
T
l
,T
l+1
(t) we have
d log L(t, T
m
) =

λ(t, T
m
)
m
¸
l=µ
δL(t, T
l
)
δL(t, T
l
) + 1
λ(t, T
l
) −
1
2
|λ(t, T
m
)|
2

dt
+λ(t, T
m
) dW

(t),
12.1. MODELS OF FORWARD LIBOR RATES 135
for t ∈ [0, T
µ
] and m = µ, . . . , ν −1. Write α(t, T
m
) for the above drift term,
and let t
i
=
i
n
T
µ
, i = 0, . . . , n, n ∈ N large enough, be a partition of [0, T
µ
].
Then we can approximate
log L(t
i+1
, T
m
) = log L(t
i
, T
m
) +

t
i+1
t
i
α(s, T
m
) ds +

t
i+1
t
i
λ(s, T
m
) dW

(s)
≈ log L(t
i
, T
m
) +α(t
i
, T
m
)
1
n

m
(i),
where
ζ
m
(i) :=

t
i+1
t
i
λ(s, T
m
) dW

(s),
such that ζ(i) = (ζ
µ
(i), . . . , ζ
ν−1
(i)), i = 0, . . . , n −1, are independent Gaus-
sian (ν −µ)-vectors with mean zero and covariance matrix
Cov[ζ
k
(i), ζ
l
(i)] =

t
i+1
t
i
λ(s, T
k
) λ(s, T
l
) ds,
which can easily be simulated.
Forward Swap Measure
We consider the above payer swap with reset dates T
µ
, . . . , T
ν−1
and cashflow
dates T
µ+1
, . . . , T
ν
(= maturity of the swap). The corresponding forward
swap rate at time t ≤ T
µ
is
R
swap
(t) =
P(t, T
µ
) −P(t, T
ν
)
δ
¸
ν
k=µ+1
P(t, T
k
)
=
1 −
P(t,Tν)
P(t,Tµ)
δ
¸
ν
k=µ+1
P(t,T
k
)
P(t,Tµ)
. (12.3)
Since for any 0 ≤ l < m ≤ M
P(t, T
l
)
P(t, T
m
)
=
P(t, T
l
)
P(t, T
l+1
)

P(t, T
m−1
)
P(t, T
m
)
=
m−1
¸
i=l
(1 +δL(t, T
i
)) ,
R
swap
(t) is given in terms of the above constructed LIBOR rates.
Define the positive Q

-martingale
D(t) :=
ν
¸
k=µ+1
P(t, T
k
)
P(t, T
µ
)
, t ∈ [0, T
µ
].
136 CHAPTER 12. MARKET MODELS
This induces an equivalent probability measure Q
swap
∼ Q

, the forward
swap measure, on T

by
dQ
swap
dQ

=
D(T
µ
)
D(0)
.
Lemma 12.1.3. The forward swap rate process R
swap
(t), t ∈ [0, T
µ
], is a
Q
swap
-martingale.
Proof. Let 0 ≤ m ≤ M and 0 ≤ s ≤ t ≤ T
m
∧ T
µ
. Then
E
Q
swap
¸
P(t, T
m
)
P(t, T
µ
)D(t)
[ T
s

=
1
D(s)
E
Q

¸
P(t, T
m
)
P(t, T
µ
)D(t)
D(t) [ T
s

=
1
D(s)
P(s, T
m
)
P(s, T
µ
)
.
Now the lemma follows (set m = 0, µ) by (12.3).
The payoff at maturity of the above swaption can be written as
δD(T
µ
) (R
swap
(T
0
) −K)
+
.
Hence the price is
π(0) = δP(0, T
µ
)E
Q

D(T
µ
) (R
swap
(T
0
) −K)
+

= δP(0, T
µ
)D(0)E
Q
swap

(R
swap
(T
0
) −K)
+

= δ
ν
¸
k=µ+1
P(0, T
k
)E
Q
swap

(R
swap
(T
0
) −K)
+

.
Lemma 12.1.3 tells us that R
swap
is a positive Q
swap
-martingale and hence of
the form
dR
swap
(t) = R
swap
(t)ρ
swap
(t) dW
swap
(t), t ∈ [0, T
µ
],
for some Q
swap
-Brownian motion W
swap
and some swap volatility process
ρ
swap
. Hence, under the hypothesis
(H) ρ
swap
(t) is deterministic,
12.1. MODELS OF FORWARD LIBOR RATES 137
we would have that log R
swap
(T
µ
) is Gaussian distributed under Q
swap
with
mean
log R
swap
(0) −
1
2


0

swap
(t)|
2
dt
and variance


0

swap
(t)|
2
dt.
The swaption price would then be
π(0) = δ
ν
¸
k=µ+1
P(0, T
k
) (R
swap
(0)Φ(d
1
) −KΦ(d
2
)) ,
with
d
1,2
:=
log

Rswap(0)
K

±
1
2


0

swap
(t)|
2
dt


0

swap
(t)|
2
dt
1
2
.
This is Black’s formula with volatility σ
2
given by
1
T
µ


0

swap
(t)|
2
dt.
However, one can show that ρ
swap
cannot be deterministic in our log-
normal LIBOR setup. So hypothesis (H) does not hold. For swaption pricing
it would be natural to model the forward swap rates directly and postulate
that they are log-normal under the forward swap measures. This approach
has been carried out by Jamshidian [12] and others. It could be shown, how-
ever, that then the forward LIBOR rate volatility cannot be deterministic.
So either one gets Black’s formula for caps or for swaptions, but not simulta-
neously for both. Put in other words, when we insist on log-normal forward
LIBOR rates then swaption prices have to be approximated. One possibility
is to use Monte Carlo methods. Another way (among many others) is now
sketched below.
We have seen in Section 2.4.3 that the forward swap rate can be written
as weighted sum of forward LIBOR rates
R
swap
(t) =
ν
¸
m=µ+1
w
m
(t)L(t, T
m−1
),
138 CHAPTER 12. MARKET MODELS
with weights
w
m
(t) =
P(t, T
m
)
D(t)P(t, T
µ
)
=
1
1+δL(t,Tµ)

1
1+δL(t,T
m−1
)
¸
ν
j=µ+1
1
1+δL(t,Tµ)

1
1+δL(t,T
j−1
)
.
According to empirical studies, the variability of the w
m
’s is small compared
to the variability of the forward LIBOR rates. We thus approximate w
m
(t)
by its deterministic initial value w
m
(0). So that
R
swap
(t) ≈
ν
¸
m=µ+1
w
m
(0)L(t, T
m−1
),
and hence, under the T
µ
-forward measure Q

dR
swap
(t) ≈ ( ) dt +
ν
¸
m=µ+1
w
m
(0)L(t, T
m−1
)λ(t, T
m−1
) dW

, t ∈ [0, T
µ
].
We obtain for the forward swap volatility

swap
(t)|
2
=
d 'log R
swap
, log R
swap
`
t
dt

ν
¸
k,l=µ+1
w
k
(0)w
l
(0)L(t, T
k−1
)L(t, T
l−1
)λ(t, T
k−1
) λ(t, T
l−1
)
R
2
swap
(t)
.
In a further approximation we replace all random variables by their time 0
values, such that the quadratic variation of log R
swap
(t) becomes approxima-
tively deterministic

swap
(t)|
2

ν
¸
k,l=µ+1
w
k
(0)w
l
(0)L(0, T
k−1
)L(0, T
l−1
)λ(t, T
k−1
) λ(t, T
l−1
)
R
2
swap
(0)
.
Denote the square root of the right hand side by ˜ ρ
swap
(t), and define the
Q
swap
-Brownian motion (L´evy’s characterization theorem)
W

(t) :=

t
0
d
¸
j=1
ρ
swap
j
(s)

swap
(s)|
dW
swap
j
(s), t ∈ [0, T
µ
].
12.1. MODELS OF FORWARD LIBOR RATES 139
Then we have
dR
swap
(t) = R
swap
(t)|ρ
swap
(t)| dW

(t)
≈ R
swap
(t)˜ ρ
swap
(t) dW

(t).
Hence we can approximate the swaption price in our log-normal forward
LIBOR model by Black’s swaption price formula where σ
2
is to be replaced
by
1
T
µ


0
ν
¸
k,l=µ+1
w
k
(0)w
l
(0)L(0, T
k−1
)L(0, T
l−1
)λ(t, T
k−1
) λ(t, T
l−1
)
R
2
swap
(0)
dt.
This is “Rebonato’s formula”, since it originally appears in his book R[22].
The goodness of this approximation has been tested numerically by several
authors, see BM[6](Chapter 8). They conclude that “the approximation is
satisfactory in general”.
Implied Savings Account
Given the LIBOR L(T
i
, T
i
) for period [T
i
, T
i+1
], for all i = 0, . . . , M − 1, we
can define the discrete-time, implied savings account process
B

(0) := 1,
B

(T
m
) := (1 +δL(T
m−1
, T
m−1
))B

(T
m−1
), m = 1, . . . , M,
that is,
B

(T
n
) = B

(T
m
)
n−1
¸
k=m
1
P(T
k
, T
k+1
)
, m < n ≤ M.
Hence B

(T
m
) can be interpreted as the cash amount accumulated up to time
T
m
by rolling over a series of zero-coupon bonds with the shortest maturities
available.
By construction, B

is a strictly increasing and predictable process with
respect to the discrete-time filtration (T
Tm
), that is,
B

(T
m
) is T
T
m−1
-measurable, for all m = 1, . . . , M.
Lemma 12.1.4. For all 0 ≤ m ≤ M we have
E
Q
T
M
[B

(T
M
) [ T
Tm
] =
B

(T
m
)
P(T
m
, T
M
)
.
140 CHAPTER 12. MARKET MODELS
Proof. Exercise.
Lemma 12.1.4 yields in particular
E
Q
T
M
[B

(T
M
)P(0, T
M
)] = 1 and B

(T
M
)P(0, T
M
) > 0,
so that we can define the equivalent probability measure Q

∼ Q
T
M
on T
T
M
by
dQ

dQ
T
M
= B

(T
M
)P(0, T
M
).
Q

can be interpreted as risk neutral martingale measure since
P(T
k
, T
l
) = E
Q

¸
B

(T
k
)
B

(T
l
)
[ T
T
k

, 0 ≤ k ≤ l ≤ M. (12.4)
Indeed, in view of Lemma 12.1.4 we have for m ≤ M
dQ

dQ
T
M
[
T
Tm
= B

(T
m
)
P(0, T
M
)
P(T
m
, T
M
)
.
Hence (Bayes again)
E
Q

¸
B

(T
k
)
B

(T
l
)
[ T
T
k

=
E
Q
T
M

B

(T
k
)
B

(T
l
)
B

(T
l
)
P(T
l
,T
M
)
[ T
T
k

B

(T
k
)
P(T
k
,T
M
)
= P(T
k
, T
l
),
which proves (12.4). Put in other words, (12.4) shows that for any 0 ≤ l ≤ M
the discrete-time process

P(T
k
, T
l
)
B

(T
k
)

k=0,...,l
is a Q

-martingale with respect to (T
T
k
).
12.1.2 Continuous-tenor Case
We now specify the continuum of all forward LIBOR rates L(t, T), for T ∈
[0, T
M−1
]. Given the discrete-tenor skeleton constructed in the previous sec-
tion, it is enough to fill the gaps between the T
j
s. Each forward LIBOR rate
L(t, T) will follow a lognormal process under the forward measure for the
date T +δ.
The stochastic basis is the same as before. In addition, we now need a
continuum of initial dates:
12.1. MODELS OF FORWARD LIBOR RATES 141
• for every T ∈ [0, T
M−1
], an R
d
-valued, bounded, deterministic function
λ(t, T), t ∈ [0, T], which represents the volatility of L(t, T);
• an initial strictly positive and decreasing term structure
P(0, T), T ∈ [0, T
M
],
and hence an initial strictly positive forward LIBOR curve
L(0, T) =
1
δ

P(0, T)
P(0, T +δ)
−1

, T ∈ [0, T
M−1
].
First, we construct a discrete-tenor model for L(t, T
m
), m = 0, . . . , M−1,
as in the previous section.
Second, we focus on the forward measures for dates T ∈ [T
M−1
, T
M
]. We
do not have to take into account forward LIBOR rates for these dates, since
they are not defined there. However, we are given the values of the implied
savings account B

(T
M−1
) and B

(T
M
) and the probability measure Q

. By
monotonicity there exists a unique deterministic increasing function
α : [T
M−1
, T
M
] → [0, 1]
with α(T
M−1
) = 0 and α(T
M
) = 1, such that
log B

(T) := (1 −α(T)) log B

(T
M−1
) +α(T) log B

(T
M
)
satisfies
P(0, T) = E
Q

¸
1
B

(T)

, ∀T ∈ [T
M−1
, T
M
].
Let T ∈ [T
M−1
, T
M
]. Since (→ exercise) B

(T) is T
T
-measurable, strictly
positive and
E
Q

¸
1
B

(T)P(0, T)

= 1
we can define the T-forward measure Q
T
∼ Q

on T
T
by
dQ
T
dQ

=
1
B

(T)P(0, T)
.
Then we have
dQ
T
dQ
T
M
=
dQ
T
dQ

dQ

dQ
T
M
=
B

(T
M
)P(0, T
M
)
B

(T)P(0, T)
.
142 CHAPTER 12. MARKET MODELS
By the representation theorem for Q
T
M
-martingales there exists a unique
σ
T,T
M
∈ L such that (→ exercise)
dQ
T
dQ
T
M
[
Tt
= E
Q
T
M
¸
B

(T
M
)P(0, T
M
)
B

(T)P(0, T)
[ T
t

= exp

t
0
σ
T,T
M
(s) dW
T
M
(s) −
1
2

t
0

T,T
M
(s)|
2
ds

= c
t

σ
T,T
M
W
T
M

,
for t ∈ [0, T]. Girsanov’s theorem tells us that
W
T
(t) := W
T
M
(t) −

t
0
σ
T,T
M
(s) ds, t ∈ [0, T],
is a Q
T
-Brownian motion.
Third, since T ∈ [T
M−1
, T
M
] was arbitrary, we can now define the forward
LIBOR process L(t, T) for any T ∈ [T
M−2
, T
M−1
] as
dL(t, T) = L(t, T)λ(t, T) dW
T+δ
(t),
L(0, T) =
1
δ

P(0, T)
P(0, T +δ)
−1

.
This in turn defines the positive and bounded process
σ
T,T+δ
(t) :=
δL(t, T)
δL(t, T) + 1
λ(t, T), t ∈ [0, T],
for any T ∈ [T
M−2
, T
M−1
]. The forward measures for T ∈ [T
M−2
, T
M−1
] are
now given by
dQ
T
dQ
T+δ
= c
T

σ
T,T+δ
W
T+δ

.
Hence we have (→ exercise)
dQ
T
dQ
T
M
[
Tt
=
dQ
T
dQ
T+δ
[
Tt
dQ
T+δ
dQ
T
M
[
Tt
= c
t

σ
T,T+δ
W
T+δ

c
t

σ
T+δ,T
M
W
T
M

= c
t

σ
T,T
M
W
T
M

, t ∈ [0, T],
12.1. MODELS OF FORWARD LIBOR RATES 143
for any T ∈ [T
M−2
, T
M−1
], where
σ
T,T
M
:= σ
T,T+δ

T+δ,T
M
.
Proceeding by backward induction yields the forward measure Q
T
and
Q
T
-Brownian motion W
T
for all T ∈ [0, T
M
], and forward LIBOR rates
L(t, T) for all T ∈ [0, T
M−1
].
This way, we obtain the zero-coupon bond prices for all maturities. In-
deed, for any 0 ≤ T ≤ S ≤ T
M
, it is reasonable to define (why?) the forward
price process
P(t, S)
P(t, T)
:=
P(0, S)
P(0, T)
dQ
S
dQ
T
[
Tt
=
P(0, S)
P(0, T)
dQ
S
dQ
T
M
[
Tt
dQ
T
M
dQ
T
[
Tt
=
P(0, S)
P(0, T)
c
t

−σ
T,S
W
T

, t ∈ [0, T],
where (→ exercise)
σ
T,S
:= σ
T,T
M
−σ
S,T
M
.
In particular, for t = T we get
P(T, S) =
P(0, S)
P(0, T)
c
T

−σ
T,S
W
T

.
Notice that now P(T, S) may be greater than 1, unless S −T = mδ for some
integer m. Hence even though all δ-period forward LIBOR rates L(t, T) are
positive, there may be negative interest rates for other than δ periods.
144 CHAPTER 12. MARKET MODELS
Chapter 13
Default Risk
→ [24, Chapter 2], [1], etc.
So far bond price processes P(t, T) had the property that P(T, T) = 1.
That is, the payoff was certain, there was no risk of default of the issuer. This
may be the case for treasury bonds. Corporate bonds however may bear a
substantial risk of default. Investors should be adequately compensated by
a risk premium, which is reflected by a higher yield on the bond.
For the modelling of credit risk we have to consider the following risk
elements:
• Default probabilities: probability that the debtor will default on its
obligations to repay its debt.
• Recovery rates: proportion of value delivered after default has occurred.
• Transition probabilities: between credit ratings (credit migration).
Usually one has to model objective (for the rating) and risk-neutral (for the
pricing) probabilities.
13.1 Transition and Default Probabilities
There are three main approaches to the modelling of transition and default
probabilities:
• Historical method: rating agencies determine default and transition
probabilities by counting defaults that actually occurred in the past
for different rating classes.
145
146 CHAPTER 13. DEFAULT RISK
• Structural approach: models the value of a firm’s assets. Default is
when this value hits a certain lower bound. Goes back to Merton
(1974) [18].
• Intensity based method: default is specified exogenously by a stopping
time with given intensity process.
We briefly discuss the first two approaches in this section. The intensity
based method is treated in more detail in Section 13.2 below.
13.1.1 Historical Method
Rating agencies provide timely, objective information and credit analysis of
obligors. Usually they operate without government mandate and are inde-
pendent of any investment banking firm or similar organization. Among
the biggest US agencies are Moody’s Investors Service and Standard&Poor’s
(S&P).
After issuance and assignment of the initial obligor’s rating, the rating
agency regularly checks and adjusts the rating. If there is a tendency observ-
able that may affect the rating, the obligor is set on the Rating Review List
(Moody’s) or the Credit Watch List (S&P). The number of Moody’s rated
obligors has increased from 912 in 1960 to 3841 in 1997.
The formal definition of default and transition rates is the following.
Definition 13.1.1. 1. The historical one-year default rate, based on the
time frame [Y
0
, Y
1
], for an R-rated issuer is
d
R
:=
¸
Y
1
y=Y
0
M
R
(y)
¸
Y
1
y=Y
0
N
R
(y)
,
where N
R
(y) is the number of issuers with rating R at beginning of year
y, and M
R
(y) is the number of issuers with rating R at beginning of
year y which defaulted in that year.
2. The historical one-year transition rate from rating R to R
t
, based on
the time frame [Y
0
, Y
1
], is
tr
R,R
:=
¸
Y
1
y=Y
0
M
R,R
(y)
¸
Y
1
y=Y
0
N
R
(y)
,
13.1. TRANSITION AND DEFAULT PROBABILITIES 147
Table 13.1: Rating symbols.
S&P Moody’s Interpretation
Investment-grade ratings
AAA Aaa Highest quality, extremely strong
AA+ Aa1
AA Aa2 High quality
AA- Aa3
A+ A1
A A2 Strong payment capacity
A- A3
BBB+ Baa1
BBB Baa2 Adequate payment capacity
BBB- Baa3
Speculative-grade ratings
BB+ Ba1 Likely to fulfill obligations
BB Ba2 ongoing uncertainty
BB- Ba3
B+ B1
B B2 High risk obligations
B- B3
CCC+ Caa1
CCC Caa2 Current vulnerability to default
CCC- Caa3
CC
C Ca In bankruptcy or default
D or other marked shortcoming
where N
R
(y) is as above, and M
R,R
(y) is the number of issuers with
rating R at beginning of year y and R
t
at the end of that year.
Transition rates are gathered in a transition matrix as shown in Ta-
ble 13.2.
The historical method has several shortcomings:
• It neglects the default rate volatility. Transition and default probabili-
ties are dynamic and vary over time, depending on economic conditions.
148 CHAPTER 13. DEFAULT RISK
Table 13.2: S&P’s one-year transition and default rates, based on the
time frame [1980,2000] (Standard&Poor’s, Ratings Performance 2000,
see http://financialcounsel.com/Articles/Investment/ARTINV0000069-
2000Ratings.pdf).
Rating at end of year (R
t
)
Initial AAA AA A BBB BB B CCC D
rating (R)
AAA 93.66 5.83 0.40 0.09 0.03 0.00 0.00 0.00
AA 0.66 91.72 6.94 0.49 0.06 0.09 0.02 0.01
A 0.07 2.25 91.76 5.18 0.49 0.20 0.01 0.04
BBB 0.03 0.26 4.83 89.24 4.44 0.81 0.16 0.24
BB 0.03 0.06 0.44 6.66 83.23 7.46 1.05 1.08
B 0.00 0.10 0.32 0.46 5.72 83.62 3.84 5.94
CCC 0.15 0.00 0.29 0.88 1.91 10.28 61.23 25.26
• It neglects cross-country differences and business cycle effects.
• Rating agencies react too slow to change ratings. There is a systematic
overestimation of tr
R,R
and d
R
, and hence underestimation of tr
R,R
for
some R = R
t
.
13.1.2 Structural Approach
Merton [18] proposed a simple capital structure of a firm consisting of equity
and one type of zero coupon debt with promised terminal constant payoff
X > 0 at maturity T. The obligor (=the firm) defaults by T if the total
market value of its assets V (T) at T is less than its liabilities X. Thus the
probability of default by time T conditional on the information available at
t ≤ T is
p
d
(t, T) = P[V (T) < X [ T
t
] ,
with respect to some stochastic basis (Ω, T, (T
t
)
t∈[0,T]
, P). The dynamics of
V (t) is modelled as geometric Brownian motion
dV (t)
V (t)
= µdt +σ dW(t), t ∈ [0, T],
13.1. TRANSITION AND DEFAULT PROBABILITIES 149
that is
V (T) = V (t) exp

σ(W(T) −W(t)) +

µ −
1
2
σ
2

(T −t)

, t ∈ [0, T].
Then we have
p
d
(t, T) = Φ

¸
log

X
V (t)

µ −
1
2
σ
2

(T −t)
σ

T −t

, t ∈ [0, T].
If the firm value process V (t) is continuous, as in the Merton approach,
the instantaneous probability of default (∂
+
T
p
d
(t, T)[
T=t
) is zero. To include
“unexpected” defaults one has to consider firm value processes with jumps.
Zhou (1997) models V (t) as jump-diffusion process
V (T) = V (t)

¸
N(T)
¸
j=N(t)+1
e
Z
j

e

µ−
σ
2
2

(T−t)+σ(W(T)−W(t))
,
where N(t) is a Poisson process with intensity λ and Z
1
, Z
2
, . . . is a sequence
of i.i.d. Gaussian ^(m, ρ
2
) distributed random variables. It is assumed that
W, N and Z
j
are mutually independent. A dynamic description of V is
V (t) = V (0) +

t
0
V (s) (µds +σ dW(s)) +
N(t)
¸
j=1
V (τ
j
−)

e
Z
j
−1

,
where τ
1
, τ
2
, . . . are the jump times of N.
It is clear that the distribution of log V (T) conditional on T
t
and N(T) −
N(t) = n is Gaussian with mean
log V (t) +mn +

µ −
σ
2
2

(T −t)
and variance

2

2
(T −t).
150 CHAPTER 13. DEFAULT RISK
Hence the conditional default probability
p
d
(t, T) = P[log V (T) < log X [ T
t
]
=

¸
n=0
P[log V (T) < log X [ T
t
, N(T) −N(t) = n] P[N(T) −N(t) = n]
=

¸
n=0
Φ

¸
log

X
V (t)

−mn −

µ −
σ
2
2

(T −t)


2

2
(T −t)

e
−λ(T−t)
(λ(T −t))
n
n!
First passage time models make this approach more realistic by admitting
default at any time T
d
∈ [0, T], and not just at maturity T. That means,
bankruptcy occurs if the firm value V (t) hits a specified stochastic boundary
X(t), such that
T
d
= inf¦t [ V (t) ≤ X(t)¦.
In this case the conditional default probability is
p
d
(t, T) = P[T
d
≤ T [ T
t
] , t ∈ [0, T],
which can be determined by Monte Carlo simulation.
13.2 Intensity Based Method
Default is often a complicated event. The precise conditions under which
it must occur (such as hitting a barrier) are easily misspecified. The above
structural approach has the additional deficiency that it is usually difficult
to determine and trace a firm’s value process.
In this section we focus directly on describing the evolution of the default
probabilities p
d
(t, T) without defining the exact default event. Formally, we
fix a probability space (Ω, T, P). The flow of the complete market information
is represented by a filtration (T
t
) satisfying the usual conditions. The default
time T
d
is assumed to be an (T
t
)-stopping time, hence the right-continuous
default process
H(t) := 1
|T
d
≤t¦
is (T
t
)-adapted. The T
t
-conditional default probability is now
p
d
(t, T) = E[H(T) [ T
t
] , t ∈ [0, T].
13.2. INTENSITY BASED METHOD 151
Obviously, H is a uniformly integrable submartingale. By the Doob–Meyer
decomposition ([14, Theorem 1.4.10]) there exists a unique (T
t
)-predictable
1
increasing process A(t) such that
M(t) := H(t) −A(t)
is a (uniformly integrable) martingale (notice that A(t) = A(t ∧T
d
)). Hence
p
d
(t, T) = 1
|T
d
≤t¦
+E[A(T) −A(t) [ T
t
] .
This formula is the best we can hope for in general.
We proceed in several steps towards an explicit expression for p
d
(t, T) by
making more and more restrictive assumptions (D1)–(D4).
(D1) There exists a strict sub-filtration ((
t
) ⊂ (T
t
) (partial market infor-
mation) and a ((
t
)-adapted process Λ such that
A(t) = Λ(t ∧ T
d
) and T
t
= (
t
∨ H
t
,
where H
t
:= σ(H(s) [ s ≤ t) and (
t
∨ H
t
stands for the smallest
σ-algebra containing (
t
and H
t
.
A market participant with access to the partial market information (
t
cannot
observe whether default has occurred by time t (T
d
≤ t) or not (T
d
> t). In
other words, T
d
is not a stopping time for ((
t
). This nicely reflects the
aforementioned difficulties to determine the exact default event in practice.
Intuitively speaking, events in T
t
are (
t
-observable given that T
d
> t.
The formal statement is as follows.
Lemma 13.2.1. Let t ∈ R
+
. For every A ∈ T
t
there exists B ∈ (
t
such that
A ∩ ¦T
d
> t¦ = B ∩ ¦T
d
> t¦. (13.1)
Proof. Let
T

t
:= ¦A ∈ T
t
[ ∃B ∈ (
t
with property (13.1)¦ .
1
The (F
t
)-predictable σ-algebra on R
+
× Ω is generated by all left-continuous (F
t
)-
adapted processes; or equivalently, by the sets {0} ×B where B ∈ F
0
and (s, t] ×B where
s < t and B ∈ F
s
.
152 CHAPTER 13. DEFAULT RISK
Clearly (
t
⊂ T

t
. Simply take B = A. Moreover H
t
⊂ T

t
. Indeed, for every
A ∈ H
t
the intersection A∩ ¦T
d
> t¦ is either ∅ or ¦T
d
> t¦, so we can take
for B either ∅ or Ω.
Since T

t
is a σ-algebra (→ exercise) and T
t
is defined to be the smallest
σ-algebra containing (
t
and H
t
, we conclude that T
t
⊂ T

t
. This proves the
lemma.
(D2) The default probability by t as seen by a (
t
-informed observer satisfies
0 < P[T
d
≤ t [ (
t
] < 1.
Hence we can define the positive ((
t
)-adapted hazard process Γ by
e
−Γ(t)
:= P[T
d
> t [ (
t
] .
Notice that X(t) := P[T
d
> t [ (
t
] is a ((
t
)-supermartingale and E[X(t)] is
right-continuous in t (→ exercise). Hence X(t), and thus Γ(t), admits a
right-continuous modification, see e.g. [14, Theorem I.3.13]. We show below
(Lemma 13.2.4) the rather surprising fact that if Γ is regular enough then it
coincides with Λ on [0, T
d
].
A consequence of the next lemma is that for any T
t
-measurable random
variable Y there exists an (
t
-measurable random variable
˜
Y such that Y =
˜
Y
on ¦T
d
> t¦.
Lemma 13.2.2. Let t ∈ R
+
and Y a random variable. Then
E

1
|T
d
>t¦
Y [ T
t

= 1
|T
d
>t¦
e
Γ(t)
E

1
|T
d
>t¦
Y [ (
t

. (13.2)
Proof. Let A ∈ T
t
. By Lemma 13.2.1 there exists a B ∈ (
t
with (13.1), and
so 1
A
1
|T
d
>t¦
= 1
B
1
|T
d
>t¦
. Hence, by the very definition of the (
t
-conditional
expectation,

A
1
|T
d
>t¦
Y P[T
d
> t [ (
t
] dP =

B
1
|T
d
>t¦
Y P[T
d
> t [ (
t
] dP
=

B
E

1
|T
d
>t¦
Y [ (
t

P[T
d
> t [ (
t
] dP
=

B
1
|T
d
>t¦
E

1
|T
d
>t¦
Y [ (
t

dP
=

A
1
|T
d
>t¦
E

1
|T
d
>t¦
Y [ (
t

dP.
13.2. INTENSITY BASED METHOD 153
This implies
E

1
|T
d
>t¦
Y P[T
d
> t [ (
t
] [ T
t

= 1
|T
d
>t¦
E

1
|T
d
>t¦
Y [ (
t

,
which proves the lemma.
As a consequence of the preceding lemmas we may now formulate the
following results, which contain an expression for the aforementioned default
probabilities.
Lemma 13.2.3. For any t ≤ T we have
P[T
d
> T [ T
t
] = 1
|T
d
>t¦
E

e
Γ(t)−Γ(T)
[ (
t

, (13.3)
P[t < T
d
≤ T [ T
t
] = 1
|T
d
>t¦
E

1 −e
Γ(t)−Γ(T)
[ (
t

. (13.4)
Moreover, the processes
L(t) := 1
|T
d
>t¦
e
Γ(t)
= (1 −H(t))e
Γ(t)
is an (T
t
)-martingale.
Proof. Let t ≤ T. Then 1
|T
d
>T¦
= 1
|T
d
>t¦
1
|T
d
>T¦
. Using this and (13.2) we
derive
P[T
d
> T [ T
t
] = E

1
|T
d
>t¦
1
|T
d
>T¦
[ T
t

= 1
|T
d
>t¦
e
Γ(t)
E

1
|T
d
>T¦
[ (
t

= 1
|T
d
>t¦
e
Γ(t)
E

E

1
|T
d
>T¦
[ (
T

[ (
t

= 1
|T
d
>t¦
e
Γ(t)
E

e
−Γ(T)
[ (
t

,
which proves (13.3). Equation (13.4) follows since
1
|t<T
d
≤T¦
= 1
|T
d
>t¦
−1
|T
d
>T¦
.
For the second statement it is enough to consider
E[L(T) [ T
t
] = E

1
|T
d
>t¦
1
|T
d
>T¦
e
Γ(T)
[ T
t

= 1
|T
d
>t¦
e
Γ(t)
E

1
|T
d
>T¦
e
Γ(T)
[ (
t

= L(t),
since by definition of Γ
E

1
|T
d
>T¦
e
Γ(T)
[ (
t

= E

E

1
|T
d
>T¦
[ (
T

e
Γ(T)
[ (
t

= 1.
154 CHAPTER 13. DEFAULT RISK
(D3) There exists a positive, measurable, ((
t
)-adapted process λ such that
Γ(t) =

t
0
λ(s) ds.
Taking (formally) the right-hand T-derivative at T = t in (13.4) gives λ(t).
Hence we refer to λ(t) as default intensity.
Here is the announced result for Γ.
Lemma 13.2.4. The process
N(t) := H(t) −

t
0
λ(s)1
|T
d
>s¦
ds
is an (T
t
)-martingale. Hence, by the uniqueness of the predictable Doob–
Meyer decomposition, we have
Λ(t ∧ T
d
) =

t
0
λ(s)1
|T
d
>s¦
ds = Γ(t ∧ T
d
).
Proof. Let t ≤ T. In view of (13.3) we have
E[N(T) [ T
t
] = 1 −E

1
|T
d
>T¦
[ T
t

t
0
λ(s)1
|T
d
>s¦
ds

T
t
E

λ(s)1
|T
d
>s¦
[ T
t

ds
= 1 −1
|T
d
>t¦
E

e

T
t
λ(u) du
[ (
t

t
0
λ(s)1
|T
d
>s¦
ds

T
t
1
|T
d
>t¦
e

t
0
λ(u) du
E

λ(s)1
|T
d
>s¦
[ (
t

ds
. .. .
=:I
.
We have further
I =

T
t
1
|T
d
>t¦
e

t
0
λ(u) du
E

λ(s)E

1
|T
d
>s¦
[ (
s

[ (
t

ds
= 1
|T
d
>t¦
E
¸
T
t
λ(s)e

s
t
λ(u) du
ds [ (
t

= 1
|T
d
>t¦
E

1 −e

T
t
λ(u) du
[ (
t

,
13.2. INTENSITY BASED METHOD 155
hence
E[N(T) [ T
t
] = 1 −1
|T
d
>t¦

t
0
λ(s)1
|T
d
>s¦
ds = N(t).
The next and last assumption leads the way to implement a default risk
model.
(D4) P[T
d
> t [ (

] = P[T
d
> t [ (
t
] ∀t ∈ R
+
.
It can be shown that (D4) is equivalent to the hypothesis
(H) Every square integrable ((
t
)-martingale is an (T
t
)-martingale.
For more details we refer to [1, Chapter 6]. For the next lemma we only
assume (D1), (D2) and (D4).
Lemma 13.2.5. Suppose Γ is continuous. Then φ := Γ(T
d
) is an exponential
random variable with parameter 1 and independent of (

. Moreover,
T
d
= inf ¦t [ Γ(t) ≥ φ¦ .
Proof. By assumption,
P[T
d
> t [ (

] = e
−Γ(t)
.
Hence Γ(t) is non-decreasing and continuous. We can define its right inverse
C(s) := inf¦t [ Γ(t) > s¦.
Then Γ(t) > s ⇔t > C(s) and Γ(C(s)) = s, so
P[Γ(T
d
) > s [ (

] = P[T
d
> C(s) [ (

] = e
−Γ(C(s))
= e
−s
.
This proves that φ = Γ(T
d
) is an exponential random variable with parameter
1 and independent of (

. Moreover,
T
d
= inf¦t [ Γ(t) ≥ Γ(T
d
)¦ = inf¦t [ Γ(t) ≥ φ¦.
156 CHAPTER 13. DEFAULT RISK
13.2.1 Construction of Intensity Based Models
The construction of a model that satisfies (D1)–(D4) is straightforward.
We start with a filtration ((
t
) satisfying the usual conditions and
(

= σ((
t
[ t ∈ R
+
) ⊂ T.
Let λ(t) be a positive, measurable, ((
t
)-adapted process with the property

t
0
λ(s) ds < ∞ a.s. for all t ∈ R
+
.
We then fix an exponential random variable φ with parameter 1 and inde-
pendent of (

, and define the random time
T
d
:= inf

t [

t
0
λ(s) ds ≥ φ

with values in (0, ∞]. Consequently, we have for t ≤ T
P[T
d
> T [ (
t
] = P
¸
φ >

T
0
λ(u) du [ (
t

= E
¸
P
¸
φ >

T
0
λ(u) du [ (
T

[ (
t

= E

e

T
0
λ(u) du
[ (
t

,
by the independence of φ and (
T
(this is a basic lemma for conditional
expectations). And it is an easy exercise to show that
0 < P[T
d
> t [ (
t
] = e

t
0
λ(u) du
< 1 and φ =

T
d
0
λ(u) du.
We finally define T
t
:= (
t
∨ H
t
, where H
t
= σ(H(s) [ s ≤ t). Conditions
(D1)–(D3) are obviously satisfied for
Λ(t) = Γ(t) :=

t
0
λ(s) ds.
As for (D4) we notice that
P[T
d
> t [ (

] = P
¸
φ >

t
0
λ(u) du [ (

= e

t
0
λ(u) du
= P[T
d
> t [ (
t
] .
13.2. INTENSITY BASED METHOD 157
13.2.2 Computation of Default Probabilities
When it comes to computations of the default probabilities (13.3) we need a
tractable model for the intensity process λ. But the right-hand side of (13.3)
looks just like what we had for the risk-neutral valuation of zero-coupon
bonds in terms of a given short rate process (Chapter 7). Notice that λ ≥ 0
is essential. An obvious and popular choice for λ is thus a square root (or
affine) process. So let W be a ((
t
)-Brownian motion, b ≥ 0, β ∈ R and σ > 0
some constants, and let
dλ(t) = (b +βλ(t)) dt +σ

λ(t) dW(t), λ(0) ≥ 0. (13.5)
The proof of the following lemma is left as an exercise.
Lemma 13.2.6. For the intensity process (13.5) the conditional default prob-
ability is
p
d
(t, T) = P[T
d
≤ T [ T
t
] =

1 −e
−A(T−t)−B(T−t)λ(t)
, if T
d
> t
0, else,
where
A(u) := −
2b
σ
2
log

2γe
(γ−β)u/2
(γ −β) (e
γu
−1) + 2γ

,
B(u) :=
2 (e
γu
−1)
(γ −β) (e
γu
−1) + 2γ
,
γ :=

β
2
+ 2σ
2
.
13.2.3 Pricing Default Risk
The stochastic setup is as above. In addition, we suppose now that we are
given a risk-neutral probability measure Q ∼ P and a measurable, ((
t
)-
adapted short rate process r(t). Moreover, we assume that there exists a
positive, measurable, ((
t
)-adapted process λ
Q
such that
Γ
Q
(t) :=

t
0
λ
Q
(s) ds < ∞ a.s. for all t ∈ R
+
,
and (D1)–(D3) are satisfied for Q, Λ
Q
:= Γ
Q
and Γ
Q
replacing P, Λ and
Γ, respectively (unfortunately, these conditions are not preserved under an
158 CHAPTER 13. DEFAULT RISK
equivalent change of measure in general). So that Lemmas 13.2.1–13.2.4
apply.
We will determine the price C(t, T) of a corporate zero-coupon bond with
maturity T, which may default. As for the recovery we fix a constant recovery
rate δ ∈ (0, 1) and distinguish three cases:
• Zero recovery: the cashflow at T is 1
|T
d
>T¦
.
• Partial recovery at maturity: the cashflow at T is 1
|T
d
>T¦
+δ1
|T
d
≤T¦
.
• Partial recovery at default: the cashflow is

1 at T if T
d
> T,
δ at T
d
if T
d
≤ T.
Zero-Recovery
The arbitrage price of C(t, T) is
C(t, T) = E
Q

e

T
t
r(s) ds
1
|T
d
>T¦
[ T
t

.
In view of Lemma 13.2.2 this is
C(t, T) = 1
|T
d
>t¦
e

t
0
λ
Q
(s) ds
E
Q

e

T
t
r(s) ds
1
|T
d
>T¦
[ (
t

= 1
|T
d
>t¦
e

t
0
λ
Q
(s) ds
E
Q

e

T
t
r(s) ds
E
Q

1
|T
d
>T¦
[ (
T

[ (
t

= 1
|T
d
>t¦
E
Q

e

T
t
(r(s)+λ
Q
(s))ds
[ (
t

.
(13.6)
Notice that this is a very nice formula. Pricing a corporate bond boils down
to the pricing of a non-defaultable zero-coupon bond with the short rate
process replaced by
r(s) + λ
Q
(s) ≥ r(s).
A tractable (hence affine) model is easily found. For the short rates we chose
CIR: let W be a (Q, (
t
)-Brownian motion, b ≥ 0, β ∈ R, σ > 0 constant
parameters and
dr(t) = (b +βr(t)) dt +σ

r(t) dW(t), r(0) ≥ 0. (13.7)
For the intensity process we chose the affine combination
λ
Q
(t) = c
0
+c
1
r(t), (13.8)
for two constants c
0
, c
1
≥ 0.
13.2. INTENSITY BASED METHOD 159
Lemma 13.2.7. For the above affine model we have
C(t, T) = 1
|T
d
>t¦
e
−A(T−t)−B(T−t)r(t)
,
where
A(u) := c
0
u −
2b(1 +c
1
)
σ
2
log

2γe
(γ−β)u/2
(γ −β) (e
γu
−1) + 2γ

,
B(u) :=
2 (e
γu
−1)
(γ −β) (e
γu
−1) + 2γ
(1 +c
1
),
γ :=

β
2
+ 2(1 +c
1

2
.
Proof. Exercise.
A special case is c
1
= 0 (constant intensity). Here we have
C(t, T) = 1
|T
d
>t¦
e
−c
0
(T−t)
P(t, T),
where P(t, T) is the CIR price of a default-free zero-coupon bond.
Partial Recovery at Maturity
This is an easy modification of the preceding case since
1
|T
d
>T¦
+δ1
|T
d
≤T¦
= (1 −δ) 1
|T
d
>T¦
+δ.
In view of (13.6) hence
C(t, T) = (1 −δ) 1
|T
d
>t¦
E
Q

e

T
t
(r(s)+λ
Q
(s))ds
[ (
t

+δP(t, T),
where P(t, T) stands for the price of the default-free zero-coupon bond.
Partial Recovery at Default
A straightforward modification of the proofs of Lemmas 13.2.1 and 13.2.2
shows that
E
Q

1
|T
d
>t¦
Y [ (

∨ H
t

= 1
|T
d
>t¦
e

t
0
λ
Q
(s) ds
E
Q

1
|T
d
>t¦
Y [ (

160 CHAPTER 13. DEFAULT RISK
for every random variable Y . Combining this with Section 13.2.1 we obtain
for t ≤ u
Q[t < T
d
≤ u [ (

∨ H
t
] = 1
|T
d
>t¦
e

t
0
λ
Q
(s) ds
E
Q

1
|t<T
d
≤u¦
[ (

= 1
|T
d
>t¦
e

t
0
λ
Q
(s) ds

e

t
0
λ
Q
(s) ds
−e

u
0
λ
Q
(s) ds

= 1
|T
d
>t¦

1 −e

u
t
λ
Q
(s) ds

,
which is the regular conditional distribution of T
d
conditional on ¦T
d
> t¦
and (

∨ H
t
. Differentiation in with respect to u yields its density function
1
|T
d
>t¦
λ
Q
(u)e

u
t
λ
Q
(s) ds
1
|t≤u¦
.
Hence the arbitrage price of the recovery at default given that t < T
d
≤ T
is given by
π(t) = E
Q

e

T
d
t
r(s) ds
δ1
|t<T
d
≤T¦
[ T
t

= E
Q

E
Q

e

T
d
t
r(s) ds
δ1
|t<T
d
≤T¦
[ (

∨ H
t

[ T
t

= δ1
|T
d
>t¦
E
Q
¸
T
t
e

u
t
r(s) ds
λ
Q
(u)e

u
t
λ
Q
(s) ds
du [ T
t

= δ1
|T
d
>t¦

T
t
E
Q

λ
Q
(u)e

u
t
(r(s)+λ
Q
(s)) ds
[ T
t

du.
For the above affine model (13.7)–(13.8) this expression can be made more
explicit (→exercise). As a result, the price of the corporate bond bond price
with recovery at default is
C(t, T) = C
0
(t, T) +π(t),
where C
0
(t, T) is the bond price with zero recovery.
The above calculations and an extension to stochastic recovery go back
to Lando [16].
13.2.4 Measure Change
We consider an equivalent change of measure and derive the behavior of the
compensator process for the stopping time T
d
. Again, we take the above
13.2. INTENSITY BASED METHOD 161
stochastic setup and let (D1)–(D3) hold. So that
M(t) = H(t) −

t
0
λ(s)1
|T
d
>s¦
ds
is a (P, T
t
)-martingale. Now let µ be a positive ((
t
)-predictable process such
that
Λ
Q
(t) :=

t
0
µ(s)λ(s) ds < ∞ a.s. for all t ∈ R
+
.
We will construct an equivalent probability measure Q ∼ P such that
Λ
Q
(t ∧ T
d
)
is the (Q, T
t
)-compensator of H. This does not, however, imply that Λ
Q
(t)
is the (Q, (
t
)-hazard process Γ
Q
(t) = −log Q[T
d
> t [ (
t
] of T
d
in general. A
counterexample has been constructed by Kusuoka [15], see also [1, Section
7.3].
The following analysis involves stochastic calculus for cadlag processes of
finite variation (FV), which in a sense is simpler than for Brownian motion
since it is a pathwise calculus. We recall the integration by parts formula for
two right-continuous FV functions f and g
f(t)g(t) = f(0)g(0) +

t
0
f(s−) dg(s) +

t
0
g(s−) df(s) + [f, g](t),
where
[f, g](t) =
¸
0<s≤t
∆f(s)∆g(s), ∆f(s) := f(s) −f(s−).
Lemma 13.2.8. The process
D(t) := C(t)V (t)
with
C(t) := exp

t
0
(1 −µ(s))λ(s)1
|T
d
>s¦
ds

V (t) :=

1
|T
d
>t¦
+µ(T
d
)1
|T
d
≤t¦

=

1, t < T
d
µ(T
d
), t ≥ T
d
162 CHAPTER 13. DEFAULT RISK
satisfies
D(t) = 1 +

t
0
D(s−) (µ(s) −1) dM(s)
and is thus a positive P-local martingale.
Proof. Notice that [C, V ] = 0 and
V (t) = 1 +

t
0
(µ(s) −1) dH(s) = 1 +

t
0
V (s−) (µ(s) −1) dH(s).
Hence
D(t) = 1 +

t
0
C(s−) dV (s) +

t
0
V (s−) dC(s)
= 1 +

t
0
C(s−)V (s−) (µ(s) −1) dH(s)
+

t
0
C(s)V (s−)(1 −µ(s))λ(s)1
|T
d
>s¦
ds
= 1 +

t
0
D(s−) (µ(s) −1) dM(s).
Since D(s−) is locally bounded and Λ
Q
(t) < ∞ we conclude that D is a
P-local martingale.
Lemma 13.2.9. Let T ∈ R
+
. Suppose E[D(T)] = 1 (hence (D(t))
t∈[0,T]
is a
martingale), so that we can define an equivalent probability measure Q ∼ P
on T
T
by
dQ
dP
= D(T).
Then the process
M
Q
(t) := H(t) −Λ
Q
(t ∧ T
d
), t ∈ [0, T], (13.9)
is a Q-martingale.
Proof. It is enough to show that M
Q
is a Q-local martingale. Indeed, Λ
Q
is an increasing continuous (and hence predictable) process, (13.9) therefore
the unique Doob–Meyer decomposition of H under Q. Since H is uniformly
integrable, so is M
Q
([14, Theorem 1.4.10]).
13.2. INTENSITY BASED METHOD 163
From Bayes’ rule we know that M
Q
is a Q-local martingale if and only if
DM
Q
is a P-local martingale. Notice that
[D, M
Q
](t) = ∆D(T
d
)1
|T
d
≥t¦
= D(T
d
−) (µ(T
d
) −1) 1
|T
d
≥t¦
=

t
0
D(s−) (µ(s) −1) dH(s).
Integration by parts gives
DM
Q
(t) =

t
0
D(s−) dM
Q
(s) +

t
0
M
Q
(s−) dD(s) + [D, M
Q
](t)
=

t
0
D(s−) dH(s) −

t
0
D(s−)µ(s)λ(s)1
|T
d
>s¦
ds
+

t
0
M
Q
(s−) dD(s) +

t
0
D(s−) (µ(s) −1) dH(s)
=

t
0
M
Q
(s−) dD(s) +

t
0
D(s−)µ(s) dM(s),
which proves the claim.
Pricing by the “Martingale Approach”
We remark again that Λ
Q
is different from Γ
Q
in general, so that the methods
from Section 13.2.3 do not apply for the above situation. Yet, there is a way
to derive the pricing formulas from Section 13.2.3 under Assumption (D4)
for Q. The detailed analysis can be found in [1, Section 8.3].
164 CHAPTER 13. DEFAULT RISK
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[15] S. Kusuoka, A remark on default risk models, Advances in mathematical
economics, Vol. 1, Springer, Tokyo, 1999, pp. 69–82.
[16] D. Lando, On Cox processes and credit-risky securities, Rev. Derivatives
Res. 2 (1998), 99–120.
[17] R. Litterman and J.A. Scheinkman, Common factors affecting bond re-
turns, Journal of Fixed Income 1 (1991), 54–61.
[18] R. C. Merton, On the pricing for corporate debt: the risk structure of
interest rates, J. Finance 29 (1974), 449–470.
[19] M. Musiela and M. Rutkowski, Martingale methods in financial mod-
elling, Applications of Mathematics, vol. 36, Springer-Verlag, Berlin-
Heidelberg, 1997.
[20] C. Nelson and A. Siegel, Parsimonious modeling of yield curves, J. of
Business 60 (1987), 473–489.
[21] C. R. Rao, Principal component and factor analyses, Statistical methods
in finance, North-Holland, Amsterdam, 1996, pp. 489–505.
[22] R. Rebonato, Interest-rate option models, second ed., Wiley, 1998.
[23] D. Revuz and M. Yor, Continuous martingales and Brownian motion,
Grundlehren der mathematischen Wissenschaften, vol. 293, Springer-
Verlag, Berlin-Heidelberg-New York, 1994.
[24] Bernd Schmid, Pricing credit linked financial instruments, Lecture Notes
in Economics and Mathematical Systems, vol. 516, Springer-Verlag,
Berlin, 2002, Theory and empirical evidence.
BIBLIOGRAPHY 167
[25] J. Michael Steele, Stochastic calculus and financial applications, Appli-
cations of Mathematics, vol. 45, Springer-Verlag, New York, 2001.
[26] L. E. O. Svensson, Estimating and interpreting forward interest rates:
Sweden 1992-1994, IMF Working Paper No. 114, September 1994.
[27] R. Zagst, Interest-rate management, Springer-Verlag, Berlin, 2002.

2

Contents
1 Introduction 2 Interest Rates and Related Contracts 2.1 Zero-Coupon Bonds . . . . . . . . . . . . . . . . . . . 2.2 Interest Rates . . . . . . . . . . . . . . . . . . . . . . 2.2.1 Market Example: LIBOR . . . . . . . . . . . 2.2.2 Simple vs. Continuous Compounding . . . . . 2.2.3 Forward vs. Future Rates . . . . . . . . . . . 2.3 Bank Account and Short Rates . . . . . . . . . . . . 2.4 Coupon Bonds, Swaps and Yields . . . . . . . . . . . 2.4.1 Fixed Coupon Bonds . . . . . . . . . . . . . . 2.4.2 Floating Rate Notes . . . . . . . . . . . . . . 2.4.3 Interest Rate Swaps . . . . . . . . . . . . . . 2.4.4 Yield and Duration . . . . . . . . . . . . . . . 2.5 Market Conventions . . . . . . . . . . . . . . . . . . . 2.5.1 Day-count Conventions . . . . . . . . . . . . . 2.5.2 Coupon Bonds . . . . . . . . . . . . . . . . . 2.5.3 Accrued Interest, Clean Price and Dirty Price 2.5.4 Yield-to-Maturity . . . . . . . . . . . . . . . . 2.6 Caps and Floors . . . . . . . . . . . . . . . . . . . . . 2.7 Swaptions . . . . . . . . . . . . . . . . . . . . . . . . 7 9 9 11 12 12 13 14 15 16 16 17 20 22 22 23 24 25 25 29 33 33 35 36

. . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . .

3 Statistics of the Yield Curve 3.1 Principal Component Analysis (PCA) . . . . . . . . . . . . . . 3.2 PCA of the Yield Curve . . . . . . . . . . . . . . . . . . . . . 3.3 Correlation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . β const. 4. . . .1 T -Bond as Numeraire . . . . . .2 Money Markets . . . . . . . . . . . . . . . . . 4. 6. . . 4. . . . . . . . .1 Generalities . . . . . . . . . . . .1 Self-Financing Portfolios . . . . . . . . . . . . .5. . . . . . . . . . . . . . . . .1 A Bootstrapping Example . . . . . . . . . . . .1 Example: Vasicek Model (a. . .2 Arbitrage and Martingale Measures . . . . . .5. . . . . 4. . 7. . . . . . . . . . . . .3 Inverting the Yield Curve . . . . . . . . . . . . . .4 4 Estimating the Yield Curve 4. . . . . . 7. . . . . . . . . . . . . 5 Why Yield Curve Models? CONTENTS 39 39 44 45 46 48 49 65 67 67 69 73 77 77 79 82 83 83 85 85 86 87 88 89 90 92 95 97 97 99 101 . . . . . . . . . . . . 7. 4. α = 0). . . . . . . . . . . . . b.1 Bond Markets . . .2. . . . . . 7. . . .3 Hedging and Pricing . .2. . . .2.3 Problems . . . . .2 An Expectation Hypothesis . . . .2 General Case . .2. . . . . . . . . . . . . . . . . . .4 Parametrized Curve Families . . . . . . 7. . .3 Dothan Model . . . . . . . . . . . . . .5. 9. . . . . . . . . . . . . . 7. 7. . . 9. .2 Diffusion Short Rate Models . . . . . . . . . .5 Hull–White Model . . .1 Examples . . . . . . 7. .6 Option Pricing in Affine Models .2 Cox–Ingersoll–Ross Model . . . . . . . . . .3 Option Pricing in Gaussian HJM Models . . . . . . . . . . . .6. . . . . . . . . . . . . .4 Ho–Lee Model . . . . . . . . . . . . . . . . . . . . . . . . . . 7 Short Rate Models 7. . . . . . . . . . . . . . . 8 HJM Methodology 9 Forward Measures 9. . . . . . . .4 Affine Term Structures . . . . . 7. . . . . . . . . . . 7. .2. . .5. . . . . . . . . . . . . . . . . . . . . . 6 No-Arbitrage Pricing 6. . . . . . . . . .5. . . . . 7. . . . . . . . . . . . . . . . . . . . . . . .1 Vasicek Model . 7. . .5 Some Standard Models . . . 6. . . . . . .

. . . . .4 Exponential-Polynomial Families 11. 12 Market Models 12. . . . . 5 105 . . . . 13. . 148 . . . . .2 Structural Approach . . .3 Interest Rate Futures . 145 .2 Computation of Default Probabilities . . . . . . 10. . . . . 10. . . . . . . . . . . . . . . . . . . . 13. . . .1 Historical Method . . . .CONTENTS 10 Forwards and Futures 10. 13. 122 . . . . . . . . . 109 113 . . .4. .2 Svensson Family .1. . 130 . . . . . . . . . 13. . . . . . .1. . 123 127 . . . . . . 12. .2. . . . . . . . . . . . . . . . . . . . . . . 106 . . . . . . . . 122 .2 Futures Contracts . . . . . . .3 Pricing Default Risk . . . . .2 Intensity Based Method . . . . . . . . . . 118 . . . .1. 156 . . . . . . . . 160 . . . . . . . . . . . . . . . 146 . 11. . . . . . . 157 . . . . . . . . . 140 145 . . . . . . . . . Futures in a Gaussian 11 Multi-Factor Models 11. . . . . . . . .2. . . . . . . . 10. . . 13. . . . . 13 Default Risk 13. .1 No-Arbitrage Condition . . . .1 Models of Forward LIBOR Rates . . . . . . .3 Polynomial Term Structures . . . .1 Discrete-tenor Case . . 150 . . . . . 13. . . . . Setup . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117 . . . . . . .4 Measure Change . . . . . . . .2 Affine Term Structures . . . . . . . . . . . . 108 . . .1. . . . . . . . . . . . . . . . . .2 Continuous-tenor Case . . 11. . 129 . 105 . . . .1 Transition and Default Probabilities . . . .2. . . .2.1 Construction of Intensity Based Models 13.4 Forward vs. 157 . . . . 11. . . . . . . . . . 11. .1 Nelson–Siegel Family . . . . . . . . . . .1 Forward Contracts . . . . . 115 . . . . . . . . . 12. . . . .4. . . . .

6 CONTENTS .

BM[6]: Brigo–Mercurio (01) [6]. These issues should therefore not been left out. The number of books on fixed income models is growing. other than for stock derivatives. This is a book on interest rate modelling written by two quantitative analysts in financial institutions.Chapter 1 Introduction These notes have been written for a graduate course on fixed income models that I held in the fall term 2002–2003 at Princeton University. I will frequently refer to the following books: B[3]: Bj¨rk (98) [3]. which usually requires constant (zero) interest rates. many textbooks on mathematical finance have treated stochastic interest rates as an appendix to the elementary arbitrage pricing theory. in implementing and calibrating models. There are several reasons for this: • Until recently. Much emphasis is on the practical implementation and calibration of selected models. Chapters 15–20 are on interest rates. • Interest rate theory is not standardized yet: there is no well-accepted “standard” general model such as the Black–Scholes model for equities. 7 . yet it is difficult to find a convenient textbook for a one-semester course like this. • The very nature of fixed income instruments causes difficulties. A pedagogically well written introduction to matheo matical finance.

Introduction to fixed-income securities and interest rate options. Discrete time only. Written by a practitionar. A comprehensive book on financial mathematics with a large part (Part II) on interest rate modelling. I did not intend to write an entire text but rather collect fragments of the material that can be found in the above books and further references. Much emphasis is on market pricing practice. J[13]: Jarrow (96) [13]. INTRODUCTION JW[11]: James–Webber (00) [11]. R[22]: Rebonato (98) [22]. Much emphasis on market practice for pricing and handling interest rate derivatives. interest rate modelling and risk management. An encyclopedic treatment of interest rates and their related financial derivatives. A comprehensive textbook on mathematical finance. . Z[27]: Zagst (02) [27].8 CHAPTER 1. MR[19]: Musiela–Rutkowski (97) [19].

T ).Chapter 2 Interest Rates and Related Contracts Literature: B[3](Chapter 15). T ). such as coupon-bearing bonds C1 P (t. BM[6](Chapter 1). • P (t. The time t value of a dollar at time T ≥ t is expressed by the zero-coupon bond with maturity T . tn−1 ) + (1 + Cn )P (t. t1 ) + · · · + Cn−1 P (t. P (t. P(t. This is a contract which guarantees the holder one dollar to be paid at the maturity date T .T) | t 1 | T → future cashflows can be discounted. 9 . and many more 2. T ) = 1 for all T .1 Zero-Coupon Bonds A dollar today is worth more than a dollar tomorrow. • P (T. In theory we will assume that • there exists a frictionless market for T -bonds for every T > 0. T ) is continuously differentiable in T . for briefty also T -bond .

Yet. and P (T. PHt. T ) might be less than one if the issuer of the T -bond defaults. T ) ≤ 1 is a decreasing curve (which is equivalent to positivity of interest rates). March 2002 1 0.6 0. Therefore we leave away this requirement.4 0.2 Years 1 2 3 4 5 6 7 8 9 10 Note that t → P (t.2 t 1 2 3 4 5 6 7 8 9 10 A reasonable assumption would also be that T → P (t. More realistic models will be introduced and discussed in the sequel. The third condition is purely technical and implies that the term structure of zero-coupon bond prices T → P (t. already classical interest rate models imply zero-coupon bond prices greater than 1. US Treasury Bonds.6 0. . T ) are not known with certainty before t.8 0.10L 1 0.8 0.4 0. INTEREST RATES AND RELATED CONTRACTS In reality this assumptions are not always satisfied: zero-coupon bonds are not traded for all maturities. T ) is a smooth curve. T ) is a stochastic process since bond prices P (t. However.10 CHAPTER 2. this is a good starting point for doing the mathematics.

T ) P (t.T.S) The net effect is a forward investment of one dollar at time T yielding dollars at S with certainty. t. T ] is F (t. INTEREST RATES 11 2. S] prevailing at t is given by eR(t. T.S) S-bonds = zero net investment. T ) := F (t. A prototypical forward rate agreement (FRA) is a contract involving three time instants t < T < S: the current time t. T ) . T ) log P (t. the expiry time T > t. P (t. S] is R(t. t. T ) = 1 T −t 1 −1 . S) • The simple spot rate for [t. T. S) = P (t. • The simple (simply-compounded) forward rate for [T.T ) P (t. T ) := R(t. P (t. T ) = − log P (t.S) P (t. T. S) S−T P (t.2 Interest Rates The term structure of zero-coupon bond prices does not contain much visual information (strictly speaking it does). S) = − . We are led to the following definitions.2. S) := 1 P (t. • At t: sell one T -bond and buy • At T : pay one dollar. dollars. S) − log P (t. T ) ⇔ F (t.T ) P (t. and the maturity time S > T . T ) −1 .2. T ) ⇔ R(t. S) S−T • The continuously compounded spot rate for [T. A better measure is given by the implied interest rates. T ) • The continuously compounded forward rate for [T. There is a variety of them.S)(S−T ) := P (t. T −t . P (t. S] prevailing at t is given by 1+(S −T )F (t. P (t. • At S: obtain P (t.

2. t 2.1 Market Example: LIBOR “Interbank rates” are rates at which deposits between banks are exchanged.12 CHAPTER 2.1) together with the requirement P (T. • The instantaneous short rate at time t is defined by r(t) := f (t. ranging from overnight to 12 months. and at which swap transactions (see below) between banks occur. T + 1/4). ∂T (2. The most important interbank rate usually considered as a reference for fixed income contracts is the LIBOR (London InterBank Offered Rate) 1 for a series of possible maturities. t) = lim R(t. T.2. T ) is called the forward curve at time t. the three-months forward LIBOR for the period [T. For example. It is a mathematical fact that 1+ 1 R m m → eR as m → ∞. T + 1/4] at time t is given by L(t. T. T ) . To be more precise: this is the rate at which high-credit financial institutions can borrow in the interbank market. If the rate is compounded twice per year the terminal value is (1 + R/2)2 . S) = − S↓T ∂ log P (t. These rates are quoted on a simple compounding basis.1) The function T → f (t. u) du . T ). T ) = F (t. INTEREST RATES AND RELATED CONTRACTS • The instantaneous forward rate with maturity T prevailing at time t is defined by f (t.2 Simple vs. T ) = exp − f (t. T ) := lim R(t. T ) = 1 is equivalent to T P (t. T ↓t Notice that (2. . 2. Continuous Compounding One dollar invested for one year at an interest rate of R per annum growths to 1 + R. etc.

2. T )P (T. Suppose that P (t. This is equivalent to f (t. (Where do we use the assumption of a deterministic world?) The net is a riskless gain of −P (t. S)). T )P (T. If P (t. no arbitrage = no riskless. T )P (T. ∀t ≤ T ≤ S .04 = 1. S) = r(S). which contradicts the assumption. 2.2) Proof. Future Rates Can forward rates predict the future spot rates? Consider a deterministic world. u) du = T T f (T. S) (×1/P (t. S) = P (t. T )P (T. and buy P (T.2. Taking logarithm in (2. This makes the theory more tractable. S) dollars and buy one S-bond. T )P (T. S) < P (t. S) T -bonds. receive one dollar. eR = 1 + R + o(R) for R small.2) yields S S f (t. we often consider continuously compounded interest rates. S) = f (T. If markets are efficient (i. systematic profit) we have necessarily P (t.04081. This is a pure arbitrage opportunity. 13 Example: e0. S)+P (t. Then we follow the strategy: • At t: sell one S-bond. S) < 0. Since the exponential function has nicer analytic properties than power functions. S) + P (t. S) > P (t.e. Net cost: −P (t. • At T : receive P (T. ∀t ≤ T ≤ S. S) for some t ≤ T ≤ S. • At S: pay one dollar. (2. ∀t ≤ T ≤ S. S). u) du. S) the same profit can be realized by changing sign in the strategy.3 Forward vs. INTEREST RATES Moreover.2.

14

CHAPTER 2. INTEREST RATES AND RELATED CONTRACTS

(as time goes by we walk along the forward curve: the forward curve is shifted). In this case, the forward rate with maturity S prevailing at time t ≤ S is exactly the future short rate at S. The real world is not deterministic though. We will see that in general the forward rate f (t, T ) is the conditional expectation of the short rate r(T ) under a particular probability measure (forward measure), depending on T . Hence the forward rate is a biased estimator for the future short rate. Forecasts of future short rates by forward rates have little or no predictive power.

2.3

Bank Account and Short Rates

The return of a one dollar investment today (t = 0) over the period [0, ∆t] is given by 1 = exp P (0, ∆t)
∆t

f (0, u) du = 1 + r(0)∆t + o(∆t).
0

Instantaneous reinvestment in 2∆t-bonds yields 1 1 = (1 + r(0)∆t)(1 + r(∆t)∆t) + o(∆t) P (0, ∆t) P (∆t, 2∆t) at time 2∆t, etc. This strategy of “rolling over”2 just maturing bonds leads in the limit to the bank account (money-market account) B(t). Hence B(t) is the asset which growths at time t instantaneously at short rate r(t) B(t + ∆t) = B(t)(1 + r(t)∆t) + o(∆t). For ∆t → 0 this converges to dB(t) = r(t)B(t)dt and with B(0) = 1 we obtain
t

B(t) = exp
0
2

r(s) ds .

This limiting process is made rigorous in [4].

2.4. COUPON BONDS, SWAPS AND YIELDS

15

B is a risk-free asset insofar as its future value at time t + ∆t is known (up to order ∆t) at time t. In stochastic terms we speak of a predictable process. For the same reason we speak of r(t) as the risk-free rate of return over the infinitesimal period [t, t + dt]. B is important for relating amounts of currencies available at different times: in order to have one dollar in the bank account at time T we need to have T B(t) r(s) ds = exp − B(T ) t dollars in the bank account at time t ≤ T . This discount factor is stochastic: it is not known with certainty at time t. There is a close connection to the deterministic (=known at time t) discount factor given by P (t, T ). Indeed, we will see that the latter is the conditional expectation of the former under the risk neutral probability measure.

Proxies for the Short Rate → JW[11](Chapter 3.5) The short rate r(t) is a key interest rate in all models and fundamental to no-arbitrage pricing. But it cannot be directly observed. The overnight interest rate is not usually considered to be a good proxy for the short rate, because the motives and needs driving overnight borrowers are very different from those of borrowers who want money for a month or more. The overnight fed funds rate is nevertheless comparatively stable and perhaps a fair proxy, but empirical studies suggest that it has low correlation with other spot rates. The best available proxy is given by one- or three-month spot rates since they are very liquid.

2.4

Coupon Bonds, Swaps and Yields

In most bond markets, there is only a relatively small number of zero-coupon bonds traded. Most bonds include coupons.

16

CHAPTER 2. INTEREST RATES AND RELATED CONTRACTS

2.4.1

Fixed Coupon Bonds

A fixed coupon bond is a contract specified by • a number of future dates T1 < · · · < Tn (the coupon dates) (Tn is the maturity of the bond), • a sequence of (deterministic) coupons c1 , . . . , cn , • a nominal value N , such that the owner receives ci at time Ti , for i = 1, . . . , n, and N at terminal time Tn . The price p(t) at time t ≤ T1 of this coupon bond is given by the sum of discounted cashflows
n

p(t) =
i=1

P (t, Ti )ci + P (t, Tn )N.

Typically, it holds that Ti+1 −Ti ≡ δ, and the coupons are given as a fixed percentage of the nominal value: ci ≡ KδN , for some fixed interest rate K. The above formula reduces to
n

p(t) =


i=1

P (t, Ti ) + P (t, Tn ) N.

2.4.2

Floating Rate Notes

There are versions of coupon bonds for which the value of the coupon is not fixed at the time the bond is issued, but rather reset for every coupon period. Most often the resetting is determined by some market interest rate (e.g. LIBOR). A floating rate note is specified by • a number of future dates T0 < T1 < · · · < Tn , • a nominal value N . The deterministic coupon payments for the fixed coupon bond are now replaced by ci = (Ti − Ti−1 )F (Ti−1 , Ti )N,

Ti ) is determined already at time Ti−1 (this is why here we have T0 in addition to the coupon dates T1 . The time t value of −1 paid out at Ti is −P (t. . Zero net investment.3 Interest Rate Swaps An interest rate swap is a scheme where you exchange a payment stream at a fixed rate of interest for a payment stream at a floating rate (typically LIBOR). . Cost: P (t. and we note that F (Ti−1 . There are many versions of interest rate swaps. In particular. A payer interest rate swap settled in arrears is specified by • a number of future dates T0 < T1 < · · · < Tn with Ti − Ti−1 ≡ δ (Tn is the maturity of the swap). The time t value of 1 paid out at Ti is P (t. SWAPS AND YIELDS 17 where F (Ti−1 . Ti−1 ) − P (t. . Ti−1 ). The time t value of ci therefore is P (t. T0 ). Ti−1 ): P (Ti−1 . Tn ) + i=1 (P (t. Ti )) = P (t. 2. The value p(t) of this note at time t ≤ T0 is obtained as follows. Ti ) we then have ci = 1 P (Ti−1 . for t = T0 : p(T0 ) = 1.4. Ti ) − 1.4.2. but that the cash-flow ci is at time Ti . By definition of F (Ti−1 . Without loss of generality we set N = 1. . Ti−1 ) − P (t. Summing up we obtain the (surprisingly easy) formula n p(t) = P (t. COUPON BONDS. Ti ). Ti ) is the prevailing simple market interest rate. • At Ti−1 : receive one dollar and buy 1/P (Ti−1 . Ti ). Ti ) dollars. • At Ti : receive 1/P (Ti−1 . . Tn ). Ti ) Ti -bonds.Ti ) • At t: buy a Ti−1 -bond.

Its value at time t ≤ T0 is thus Πr (t) = −Πp (t). • a nominal value N . the equidistance hypothesis is only for convenience of notation and can easily be relaxed. . At Ti . Ti−1 . δ n P (t. Since P (t. Ti ) − KδP (t.3) as N δP (t. . The net cashflow at Ti is thus (F (Ti−1 . Of course. Ti ). (2. Tn . Ti−1 . Ti )). T0 ) − P (t. Ti−1 ) − P (t. Tn ) − Kδ P (t. Ti−1 ) − P (t. we can rewrite (2.3) The total value Πp (t) of the swap at time t ≤ T0 is thus n Πp (t) = N P (t. • and receives floating F (Ti−1 .18 CHAPTER 2. Ti ) . Hence Rswap (t) = P (t. Ti )δN . Ti ) = F (t. . Tn . Tn ) . The forward swap rate Rswap (t) at time t ≤ T0 is the fixed rate K above which gives Πp (t) = Πr (t) = 0. Ti ) − K)δN. Ti )δP (t. Cashflows take place only at the coupon dates T1 . . Ti ) − K) . T0 ) − P (t. . INTEREST RATES AND RELATED CONTRACTS • a fixed rate K. i=1 A receiver interest rate swap settled in arrears is obtained by changing the sign of the cashflows at times T1 . The remaining question is how the “fair” fixed rate K is determined. . . . the holder of the contract • pays fixed KδN . Ti ) (F (t. and using the previous results we can compute the value at t ≤ T0 of this cashflow as N (P (t. Ti ) i=1 The following alternative representation of Rswap (t) is sometimes useful. .

. By agreeing to swap streams of cashflows both companies could be better off.4. • Company B pays the intermediary fixed at 5 5/16% in exchange for LIBOR (payer swap). but could borrow floating at LIBOR plus 1/2%. Tj ) These weights are random. SWAPS AND YIELDS Summing up yields n 19 Πp (t) = N δ i=1 P (t. Ti ) − K) . P (t. • Company A pays LIBOR to the intermediary in exchange for fixed at 5 3/16% (receiver swap). Ti−1 . and a mediating institution would also make money. Ti ) . This is used for approximations of swaption (see below) price formulas in LIBOR market models: the swap rate volatility is written as linear combination of the forward LIBOR volatilities (“Rebonato’s formula” → BM[6]. Ti ). Swaps were developed because different companies could borrow at different rates in different markets. Ti ). Example → JW[11](p. Ti−1 .11) • Company A: is borrowing fixed for five years at 5 1/2%. Ti−1 . • Company B: is borrowing floating at LIBOR plus 1%. but there seems to be empirical evidence that the variability of wi (t) is small compared to that of F (t.2. with weights wi (t) = n j=1 P (t. COUPON BONDS. and thus we can write the swap rate as weighted average of simple forward rates n Rswap (t) = i=1 wi (t)F (t. p. Ti ) (F (t.248). but could borrow fixed for five years at 6 1/2%.

T ).4 Yield and Duration For a zero-coupon bond P (t. 2. in return for the money it makes on the spread. There is a variety of other terminologies. • The intermediary receives fixed at 1/8%. . T ) the zero-coupon yield is simply the continuously compounded spot rate R(t. INTEREST RATES AND RELATED CONTRACTS • Company A is now paying LIBOR plus 5/16% instead of LIBOR plus 1/2%. such as zero-rate curve (Z[27]).4. etc.20 Net: CHAPTER 2. That is. P (t. Accordingly. • Company B is paying fixed at 6 5/16% instead of 6 1/2%. In JW[11] the yield curve is is given by simple spot rates. 5 1/2 % Company A LIBOR 5 3/16 % Intermediary LIBOR 5 5/16 % Company B LIBOR + 1% Everyone seems to be better off. T ) = e−R(t.T )(T −t) . This risk has been partly taken up by the intermediary. this is why Company B had higher borrowing rates in the first place. T ) is referred to as (zero-coupon) yield curve. The term “yield curve” is ambiguous. zero-coupon curve (BM[6]). But there is implicit credit risk. and in BM[6] it is a combination of simple spot rates (for maturities up to 1 year) and annually compounded spot rates (for maturities greater than 1 year). the function T → R(t.

For simplicity we suppose that cn already contains N . that is. coupon payments c1 .02 Years 1 2 3 4 5 6 7 8 9 10 21 Now let p(t) be the time t market value of a fixed coupon bond with coupon dates T1 < · · · < Tn . .1). the constant (over the period [t. COUPON BONDS. etc. . The Macaulay duration of the coupon bond is defined as DM ac := n i=1 Ti ci e−yTi .4.06 0.1 0. → R[22](p. that is. and write p = p(0). Tn ]) continuously compounded rate which generates the market value of the coupon bond: the (continuously compounded) yield-tomaturity y(t) of this bond at time t ≤ T1 is defined as the unique solution to n p(t) = i=1 ci e−y(t)(Ti −t) . It is argued by Schaefer (1977) that the yield-to-maturity is an inadequate statistics for the bond market: • coupon payments occurring at the same point in time are discounted by different discount factors. Remark 2. March 2002 0. but • coupon payments at different points in time from the same bond are discounted by the same rate. Ti )ci . Again we ask for the bond’s “internal rate of interest”.4.2.08 0. t ≤ T1 . y = y(0).04 0. To simplify the notation we assume now that t = 0. . n p(t) = i=1 P (t. . p . cn and nominal value N (see Section 2.4.1. SWAPS AND YIELDS US Yield Curve.21).

1. p p i=1 with yi := R(0. In fact. The day-count convention decides upon the time measurement between two dates t and T .3) for a thourough treatment). Hence duration is essentially for bonds (w.1 Market Conventions Day-count Conventions Time is measured in years. INTEREST RATES AND RELATED CONTRACTS The duration is thus a weighted average of the coupon dates T1 . Ti ) i=1 Ti ci e D := = Ti . we have d ds n ci e−(yi +s)Ti i=1 |s=0 = −Dp. changes in the yield-to-maturity (see Z[27](Chapter 6. Ti ). C := 2 ds i=1 i=1 2. Here are three examples of day-count conventions: . . .t. T ) is given by the duration of the bond n n −yi Ti ci P (0. A first order sensitivity measure of the bond price w. parallel shifts of the entire zero-coupon yield curve T → R(0. The bond equivalent of the gamma is convexity: n n d2 −(yi +s)Ti ci e |s=0 = ci e−yi Ti (Ti )2 . parallel shift of the yield curve) what delta is for stock options.r. . If t and T denote two dates expressed as day/month/year.22 CHAPTER 2.5 2. it is not clear what T − t should be. As such it is an important concept for interest rate risk management: it acts as a measure of the first order sensitivity of the bond price w.t.5. and it provides us in a certain sense with the “mean time to coupon payment”.t. .r. This is shown by the obvious formula dp d = dy dy n ci e−yTi i=1 = −DM ac p. Tn . The market evaluates the year fraction between t and T in different ways.r.

2000 and T =July 4. m2 . and the day-count convention for T − t is given by actual number of days between t and T . • Bonds: coupon bonds (semi-annual) with time to maturity between 10 and 30 years3 .2 Coupon Bonds → MR[19](Sect. 365 • Actual/360: as above but the year counts 360 days. 11.2). y2 ). y1 ) and T = (d2 .2. . Z[27](Sect. J[13](Chapter 2) Coupon bonds issued in the American (European) markets typically have semi-annual (annual) coupon payments.1) 2. Debt securities issued by the U. Treasury are divided into three classes: • Bills: zero-coupon bonds with time to maturity less than one year. it is important to realize for which day-count convention a specific interest rate is quoted.4). m1 . Let t = (d1 .S. 5. • Notes: coupon bonds (semi-annual) with time to maturity between 2 and 10 years. the issuance of 30 year treasury bonds has been stopped. 2002 is given by 4 + (30 − 4) 7 − 1 − 1 + + 2002 − 2000 = 2.5. 360 12 Example: The time between t=January 4. 5.5. 360 12 When extracting information on interest rates from data. • 30/360: months count 30 and years 360 days. 3 Recently. MARKET CONVENTIONS 23 • Actual/365: a year has 365 days. Z[27](Sect. → BM[6](p. The day-count convention for T − t is given by min(d2 . 30) + (30 − d1 )+ (m2 − m1 − 1)+ + + y2 − y1 .2).5.

That is. They were created in response to investor demands. The accrued interest at time t ∈ (Ti−1 . t ∈ (Ti−1 . notes and bonds. or clean price. The quoted price. . the cash price. Clean Price and Dirty Price Remember that we had for the price of a coupon bond with coupon dates T1 .3 Accrued Interest. This is why prices are differently quoted at the exchange. Ti ). cn the price formula n p(t) = i=1 ci P (t. . whenever we buy a coupon bond quoted at a clean price of pclean (t) at time t ∈ (Ti−1 . or dirty price. Hence there are systematic discontinuities of the price trajectory at t = T1 . t ≤ T1 . . For t ∈ (T1 . Treasury securities called STRIPS (separate trading of registered interest and principal of securities) have traded since August 1985. INTEREST RATES AND RELATED CONTRACTS In addition to bills. Ti ). of the coupon bond at time t is pclean (t) := p(t) − AI(i. . 2. T2 ] we have n p(t) = i=2 ci P (t. These are the coupons or principal (=nominal) amounts of Treasury bonds trading separately through the Federal Reserve’s bookentry system. .5. . etc. we have to pay is p(t) = pclean (t) + AI(i. . Ti ]. . . . . Tn which is due to the coupon payments.24 CHAPTER 2. Ti ]. t). t). Ti ] is defined by AI(i. t) := ci t − Ti−1 Ti − Ti−1 (where now time differences are taken according to the day-count convention). Tn and payments c1 . They are synthetically created zero-coupon bonds of longer maturities than a year. . .

.6). LIBOR) and the strike rate κ. j−i (1 + y (Ti )/2) ˆ (1 + y (Ti )/2)n−i ˆ j=i+1 n where rc is the (annualized) coupon rate.2.6. N the nominal amount and τ = Ti+1 − t Ti+1 − Ti (semi-annual coupons).5.g. Ti+1 ) pclean (t) = rc N/2 N + . 5. Its cashflow at time T + δ is δ(F (T. j−i−1+τ (1 + y (t)/2) ˆ (1 + y (t)/2)n−i−1+τ ˆ j=i+1 n N rc N/2 + . • a cap rate κ. is again given by the day-count convention. Z[27](Sect. It thus consists of • a number of future dates T0 < T1 < · · · < Tn with Ti − Ti−1 ≡ δ (Tn is the maturity of the cap).6.6 Caps and Floors → BM[6](Sect. 1. CAPS AND FLOORS 25 2.2) Caps A caplet with reset date T and settlement date T + δ pays the holder the difference between a simple market rate F (T. and we assume here that Ti+1 − Ti ≡ 1/2 2. T + δ) − κ)+ . A cap is a strip of caplets. T + δ) (e.4 Yield-to-Maturity The quoted (annual) yield-to-maturity y (t) on a Treasury bond at time t = T i ˆ is defined by the relationship pclean (Ti ) = and at t ∈ [Ti .

. . It can be shown (→ exercise) that the cashflow (2. and n Cp(t) = i=1 Cpl(i. It guarantees that the interest to be paid on a floating rate loan never exceeds the predetermined cap rate κ. which means that caps can be priced very easily in those models. (1 + δκ) 1 − P (Ti−1 . This is an important fact because many interest rate models have explicit formulae for bond option values. .26 CHAPTER 2. . n. t) for the price of the floor. Ti ) − κ)+ . . INTEREST RATES AND RELATED CONTRACTS Cashflows take place at the dates T1 .4) at time Ti is the equivalent to (1 + δκ) times the cashflow at date Ti−1 of a put option on a Ti -bond with strike price 1/(1 + δκ) and maturity Ti−1 . Ti ))+ . (2. t) for the time t price of the cap.4) Let t ≤ T0 . that is. the cashflow of which is – with the same notation as above – at time Ti δ(κ − F (Ti−1 . . . At Ti the holder of the cap receives δ(F (Ti−1 . It protects against low rates. t) for the price of the ith floorlet and n F l(t) = i=1 F ll(i. for the time t price of the ith caplet with reset date Ti−1 and settlement date Ti . A cap gives the holder a protection against rising interest rates. . Write F ll(i. Ti ) 1 + δκ + . A floor is a strip of floorlets. i = 1. Floors A floor is the converse to a cap. . We write Cpl(i. Tn . t).

Ti−1 . T0 ) − P (0. δ n P (0. Black’s formula for the value of the ith floorlet is F ll(i. Cap/floor prices are quoted in the market in term of their implied volatilities. t))) . Correspondingly. Let t ≤ T0 . Ti−1 . The cap/floor is said to be at-the-money (ATM) if κ = Rswap (0) = P (0.1 and Figure 2. ± 1 σ(t)2 (Ti−1 − t) 2 √ σ(t) Ti−1 − t . CAPS AND FLOORS Caps. Typically. Ti ) i=1 the forward swap rate. t)) − F (t. Black’s Formula It is market practice to price a cap/floor according to Black’s formula.Ti ) κ (Φ stands for the standard Gaussian cumulative distribution function). one can show the parity relation (→ exercise) Cp(t) − F l(t) = Πp (t). It is a challenge for any market realistic interest rate model to match the given volatility curve. where Πp (t) is the value at t of a payer swap with rate κ. Floors and Swaps 27 Caps and floors are strongly related to swaps. Tn ) .49)). t)) − κΦ(d2 (i. Ti )Φ(−d1 (i. and σ(t) is the cap volatility (it is the same for all caplets). An example of a US dollar ATM market cap volatility curve is shown in Table 2.6. and out-of-the-money (OTM) if κ > Rswap (0) (κ < Rswap (0)). t) = δP (t. Ti )Φ(d1 (i. where log d1.2. Ti ) (F (t. Indeed. Ti−1 . nominal one and the same tenor structure as the cap and floor. Black’s formula for the value of the ith caplet is Cpl(i.1 (→ JW[11](p. Let t = 0. Ti ) (κΦ(−d2 (i. and T0 and δ = Ti − Ti−1 being equal to three months. t) = δP (t. The cap (floor) is in-the-money (ITM) if κ < Rswap (0) (κ > Rswap (0)). t))) .2 (i. t) := F (t. we have t = 0.

7 17.4 18.5 18.1 17. 23 July 1999 18% 16% 14% 12% 5 10 15 20 25 30 .1: US dollar ATM cap volatilities.1: US dollar ATM cap volatilities.8 18.4 Figure 2.7 18.4 18. INTEREST RATES AND RELATED CONTRACTS Table 2. 23 July 1999 Maturity (in years) 1 2 3 4 5 6 7 8 10 12 15 20 30 ATM vols (in %) 14.0 16.7 12.2 17.5 14.9 18.28 CHAPTER 2.

if K = Rswap (t).7 Swaptions A European payer (receiver) swaption with strike rate K is an option giving the right to enter a payer (receiver) swap with fixed rate K at a given future date. OTM . the swaption maturity. the payer (receiver) swaption with strike rate K is said to be ATM . . Here the correlation between different forward rates will enter the valuation procedure. Rswap (T0 )) = 0. Ti ). K < (>)Rswap (t). T0 . K) = N i=1 P (T0 . this payoff cannot be decomposed into more elementary payoffs. Recall that the value of a payer swap with fixed rate K at its first reset date.5) of the payer swaption at time T0 can also be written as n N δ(Rswap (T0 ) − K) and for the receiver swaption + i=1 P (T0 . Ti )δ(F (T0 .5) Notice that. Since Πp (T0 . Ti−1 . K > (<)Rswap (t).7. Ti )δ(F (T0 . Ti−1 . Ti ). respectively. Hence the payoff of the swaption with strike rate K at maturity T0 is n + N i=1 P (T0 . The underlying swap lenght Tn − T0 is called the tenor of the swaption. Accordingly.2. (2. the swaption maturity coincides with the first reset date of the underlying swap. This is a fundamental difference between caps/floors and swaptions. one can show (→ exercise) that the payoff (2. contrary to the cap case. Ti ) − K) . Usually. is n Πp (T0 . Ti ) − K). ITM . at time t ≤ T0 . SWAPTIONS 29 2. n N δ(K − Rswap (T0 )) + i=1 P (T0 .

253)). An interest model for swaptions valuation must fit the given today’s volatility surface. INTEREST RATES AND RELATED CONTRACTS Black’s Formula Black’s formula for the price at time t ≤ T0 of the payer (Swptp (t)) and receiver (Swptr (t)) swaption is n Swptp (t) = N δ (Rswap (t)Φ(d1 (t)) − KΦ(d2 (t))) P (t. Swaption prices are quoted in terms of implied volatilities in matrix form. A typical example of implied swaption volatilities is shown in Table 2.2 (t) := Rswap (t) K P (t.2 and Figure 2.2 (→ BM[6](p. i=1 n Swptr (t) = N δ (KΦ(−d2 (t)) − Rswap (t)Φ(−d1 (t))) with log d1. An x × y-swaption is the swaption with maturity in x years and whose underlying swap is y years long. Ti ). Ti ). σ(t) T0 − t . i=1 and σ(t) is the prevailing Black’s swaption volatility.30 CHAPTER 2. ± 1 σ(t)2 (T0 − t) 2 √ .

8 9.4 11.9 12.1 10.4.2. 1y 2y 3y 4y 5y 7y 10y 1y 16.1 13.8 8.5.8 10.4 6y 12.2: Black’s implied volatilities (in %) of ATM swaptions on May 16.9 11.3.1 11.3 10.4 10.4 9.1 9.9 12.7 9.8 10.4 9.7 11. SWAPTIONS 31 Table 2.5 2y 15.6 15.9 8.6 16.8 5y 13.10 years.1 8y 12.3 9.3 10.6 12.6 11.7 12.5 11. swaps lengths from 1 to 10 years.4 11. Maturity 2 4 6 8 10 16 14 Vol 12 10 2 6 4 Tenor 8 10 .4 17.9 12.5 14.8 9y 12.6 8.6 10.6 10y 11.5 9.2 11.2.7 11.5 10.7 11.5 3y 14. 2000.8 14.2: Black’s implied volatilities (in %) of ATM swaptions on May 16.9 11. 2000.6 13. Maturities are 1.3 11.1 10.0 11.0 10.9 10.9 12.7 17.4 4y 13.8 13.4 Figure 2.3 12.7 11.1 12.9 15.7.4 12.9 11.7.3 11.9 11.5 13.3 7y 12.6 14.8 15.

INTEREST RATES AND RELATED CONTRACTS .32 CHAPTER 2.

pn ) (that is. x(N ) be a sample of a random n × 1 vector x.i ) consisting of orthonormal n × 1 Eigenvectors ˆ pi of Σ such that ˆ Σ = ALAT . . . . • There exists a unique orthogonal matrix A = (p1 . [21] • Let x(1). ˆ Σij = = where 1 µ[xi ] := N − µ[xi ])(xj (k) − µ[xj ]) N −1 N k=1 xi (k)xi (k) − N µ[xi ]µ[xj ] . ˆ • Form the empirical n × n covariance matrix Σ. . . . A−1 = AT and Aij = pj. 33 . . N −1 N N k=1 (xi (k) xi (k) (mean of xi ).Chapter 3 Some Statistics of the Yield Curve 3.2). k=1 ˆ We assume that Σ is non-degenerate (otherwise we can express an xi as linear combination of the other xj s). .1 Principal Component Analysis (PCA) → JW[11](Chapter 16.

• Sometimes the following view is useful (→ R[22](Chapter 3)): set σi := V ar[xi ] vi := 1/2 ˆ = Σii n j=1 1/2 n 1/2 = j=1 A 2 λj ij λ j wj . λn ) with λ1 ≥ · · · ≥ λn > 0 (the Eigenvalues ˆ of Σ). Hence the zi s are uncorrelated. wj ] = δij . λn ).34 CHAPTER 3. . . The importance of component pi is determined by the size of the corresponding Eigenvalue. where L1/2 := diag( λ1 . . • The principal components (PCs) are the n × 1 vectors p1 . λi . ˜ ˜ n w = µ[x] + j=1 n pj λj w j . . . . . zj ] = k. . n. .l=1 T ˆ Aik Cov[xk . √ √ • Normalization: let w := (L1/2 )−1 z. . . i = 1. and x = µ[x] + AL In components xi = µ[xi ] + j=1 1/2 λj . pn : x = Az = z1 p1 + · · · zn pn . Then ˜ ˜ ˜ ˜ µ[w] = 0. The key statistics is the proportion λi n j=1 the explained variance by pi . ˜ and w = w − µ[w] (µ[w]=mean of w). Cov[wi . xi − µ[xi ] = σi Aij σi . . Then n Cov[zi . which indicates the amount of variance explained by pi . STATISTICS OF THE YIELD CURVE where L = diag(λ1 . Aij λ j wj . • Define z := AT x. . . wj ] = Cov[wi . . . xl ]AT = AT ΣA jl ij = λi δij .

176 . t + ∆t + τi−1 . The first three principal components are       0.291  0. • the second PC is upward sloping (tilt → slope). .044  0.367      p1 =  0. 3.2. PCA OF THE YIELD CURVE 2 Then we have µ[vi ] = 0. xj ] = Cov[vi . j).343 0.722 0.364 . PCA typically leads to the following picture (→ R[22]p. say for some maturity spectrum 0 = τ0 < · · · < τn . p2 =  0.        0.9)). .204 −0. vj ] = ˆ Σij = σi σj n k=1 Aik Ajk λk = ρ(π. It can be appropriate to assume a parametric functional form (→ reduction of parameters) of the correlation structure of x.161  . i.404 0. .329 −0. σi σj where π is some low-dimensional parameter (this is adapted to the calibration of market models → BM[6](Chapter 6. n = 8).121 0.455 −0. Corr[xi .368 0.358 0. µ[vi ] = 1 and 35 xi = µ[xi ] + σi vi .352 • The first PC is roughly flat (parallel shift → average rate).3. • the third PC hump-shaped (flex → curvature). t + τi−1 . t + ∆t + τi ) − R(t.268   0.365       −0.490 −0. t + τi ).316  0. Now let x = (x1 .61): UK market in the years 1989-1992 (the original maturity spectrum has been divided into eight distinct buckets. p3 = −0.361        0. xn )T be the increments of the forward curve. .354       −0. .e.176   0.2 PCA of the Yield Curve xi = R(t + ∆t. i.461  0.

STATISTICS OF THE YIELD CURVE Figure 3.1).03 6–8 0.4 0.17 2 6. Princeton University).36 CHAPTER 3.2 -0.01 PC The first three PCs explain more than 99 % of the variance of x (→ Table 3.93 3 0. Explained Variance (%) 1 92.61 4 0.24 5 0.2 2 -0.58) A typical example of correlation among forward rates is provided by .1: First Three PCs.8 3 4 5 6 7 8 Table 3. PCA of the yield curve goes back to the seminal paper by Litterman and Scheinkman (91) [17] (Prof. 3. Scheinkman is at the Department of Economics.3 Correlation → R[22](p.6 0.4 -0.6 -0.1: Explained Variance of the Principal Components (PCs). J. 0.

6 0.5 2 2. .5.87 0.95 1 shows the correlation for changes of forward rates of maturities 0.69 0.95 0.97 0.93    1 0.5 1 1.5 3 → Decorrelation occurs quickly.6  1 0.74 0. 0.8 0.7 0.2: Correlation between the short rate and instantaneous forward rates for the US Treasury curve 1987–1994 1 0. The following matrix (→ Figure 3.5.64 0. 2.99 0.2)   1 0. → Exponentially decaying correlation structure is plausible. CORRELATION 37 Brown and Schaefer (1994).3. 3 years. 1.9 0.93 0.85    1 0.3.92    1 0. Figure 3.9 0. 1. The data is from the US Treasury yield curve 1987–1994.96 0.

STATISTICS OF THE YIELD CURVE .38 CHAPTER 3.

360 Table 4. The idea is to build up the yield curve from shorter maturities to longer maturities.60 4y 2. The spot date t0 is 11 January.49 1w 0.25 Sep 96 99.1 A Bootstrapping Example → JW[11](p.56 20 19 18 18 Futures Mar 96 99. We take Yen data from 9 January.10 Dec 96 98. δ(T.01 10y 3. LIBOR (%) o/n 0. S) = actual number of days between T and S .Chapter 4 Estimating the Yield Curve 4.14 3y 1.4)). 1996.53 2m 0.50 1m 0.04 5y 2. The day-count convention is Actual/360.55 3m 0.90 Swaps (%) 2y 1.1: Yen data. 1996 (→ JW[11](Section 5.36 39 .34 Jun 96 99.43 7y 3. 9 January 1996.129–136) This is a naive bootstrapping method of fitting to a money market yield curve.

S4 )q P (t0 . . and {T1 . . respectively. . 7. that is. . T5 } = {20/3/96. S5 ). Ti . 11/4/96} hence for 1. . Ti . . . 18/12/96. The zerocoupon bonds are P (t0 . Ti+1 ) F (t0 . Ti+1 )). which is equivalent to using linear interpolation of continuously compounded spot rates R(t0 . Ti+1 ) = P (t0 . where FF (t0 . T5 ). S5 } = {12/1/96. T1 ) = P (t0 . Ti+1 ] prevailing at t0 . Ti+1 ) where to derive P (t0 . 11/3/96. 1 . 22 δ(T1 . We treat futures rates as if they were simple forward rates. . Si ) = • The futures are quoted as futures price for settlement day Ti = 100(1 − FF (t0 . 60 and 91 days to maturity. Si ) To calculate zero-coupon bond from futures prices we need P (t0 . P (t0 . 1 + F (t0 . hence δ(Ti . δ(S4 . Si ) for maturities {S1 . 33. We use geometric interpoliation P (t0 . Ti+1 ) is the futures rate for period [Ti . S4 ) + (1 − q) R(t0 . Ti+1 ) ≡ 91/360. 19/3/97}. Ti . 18/9/96. 13/2/96. Ti ) 1 + δ(Ti . Ti . S5 ) 31 Then we use the relation q= P (t0 . Ti+1 ) = FF (t0 . Ti . 18/1/96. Ti+1 ). T1 ) = q R(t0 .709677. . 19/6/96. T1 ). T2 ). S5 ) = = 0. ESTIMATING THE YIELD CURVE • The first column contains the LIBOR (=simple spot rates) F (t0 .40 CHAPTER 4. S5 )1−q . . Si ) δ(t0 . . we set F (t0 . . .

11/1. . T4 ) + 91 R(t0 .     12/7/99.1. Un )δ(Un−1 . T5 ). 8.    11/7/00. 13/1/03.    11/7/97. 11/1/01. Ui ) 41                                . For a swap with maturity Un the swap rate at t0 is given by n i=1 (U0 := t0 ). {U1 . Ui ) for i = 4.     12/7/04. T2 ) + 91 65 R(t0 . P (t0 . 91 All remaining swap rates are obtained by linear interpolation. . U1 ). U4 )). For maturity U3 this is 1 Rswap (t0 .     11/7/03. δ(Ui−1 . 12/1/98. . Un ) for n = 3. 2 We have (→ exercise) n−1 1 − Rswap (t0 . Ui ) P (t0 . U1 ). Un ) This gives P (t0 . Un ) = 1 − P (t0 . . 13/1/97. . We obtain P (t0 . Un ) = . 20. U3 ) = (Rswap (t0 .    11/7/05. . Ui ) P (t0 . Rswap (t0 . U2 ) (and hence Rswap (t0 . From the data we have Rswap (t0 . 11/1/00. U20 } =  11/7/01. . Ui ) P (t0 . 6. U2 ) + Rswap (t0 .     13/7/98. .    11/7/02. T3 ) 91 26 R(t0 . 10. U1 ) = 22 R(t0 . 05. 11/1/02. U2 ) = R(t0 . Un ) i=1 δ(Ui−1 . 1 + Rswap (t0 .4. 20. 11/1/06 Rswap (t0 . 12/1/04. . U2 )) by linear interpolation of the continuously compounded spot rates 69 R(t0 . 14. Un ) . 11/1/99. A BOOTSTRAPPING EXAMPLE • Yen swaps have semi-annual cashflows at dates   11/7/96.

Spot and forward rates are continuously compounded log P (t0 . ti+1 ) − log P (t0 . ti ) δ(t0 .42 CHAPTER 4. . . It is evident that the three curves are not coincident to a common underlying curve.8 0. non-smooth forward curve. . . t0 ) = 1). The method exactly reconstructs market prices (this is desirable for interest rate option traders). . ti . . . reflecting the derivative of T → − log P (t0 . ti ) log P (t0 . futures and swaps.2 2 4 6 8 Time to maturity 10 In Figure 4. ti ). → The entire yield curve is constructed from relatively few instruments. Figure 4. . T ). ti ) . ESTIMATING THE YIELD CURVE Figure 4. R(t0 . Our naive method made no attempt to meld the three curves together.2. ti ) = − i = 1. . 29. ti+1 ) R(t0 .6 0.4 0. The forward curve. i = 0. is very unsmooth and sensitive to slight variations (errors) in prices. ti+1 ) = − δ(ti .3 shows the spot rate curves from LIBOR. 29 (we have 29 points and set P (t0 . The spot and forward rate curves are in Figure 4.1 is the implied zero-coupon bond price curve P (t0 . But it produces an unstable.1: Zero-coupon bond curve 1 0.

forward rates (upper curve) 0.4.3: Comparison of money market curves 0.1.05 0. The amount by which the futures rate is above the forward rate is called the convexity adjustment. In reality futures rates are greater than forward rates.005 1 1.02 0.007 0. which is .009 0.011 0.5 Time to maturity 2 → Another method would be to estimate a smooth yield curve parametrically from the market rates (for fund managers.2: Spot rates (lower curve).03 0.5 0.01 0.008 0.012 0.04 0. The main difficulties with our method are: • Futures rates are treated as forward rates.006 0.01 2 4 6 8 Time to maturity 10 43 Figure 4. A BOOTSTRAPPING EXAMPLE Figure 4.06 0. long term strategies).

t0 + x) can be formulated as where p is a vector of n market prices. • LIBOR rates beyond the “stup date” T1 = 20/3/96 (that is. 4. In general. . • liquidity effects. and d = (D(x1 ). The linear interpolation produces a “sawtooth” in the forward rate curve. . and σ is the volatility parameter. However. ESTIMATING THE YIELD CURVE model dependend. • tax effects (high coupons. D(xN )) with cashflow dates t0 < T1 < · · · < TN . • round-off errors in the quotes (bid-ask spreads. etc). p = C ·d+ .2 General Case The general problem of finding today’s (t0 ) term structure of zero-coupon bond prices (or the discount function) x → D(x) := P (t0 . Ti − t 0 = x i . C the related cashflow matrix. futures and swap markets overlap. in some markets intermediate swaps are indeed priced as if their prices were found by linear interpolation. the segments of LIBOR. low coupons). Reasons for including errors are • prices are never exactly simultaneous. T1 ) is found. and a vector of pricing errors.44 CHAPTER 4. • allows for smoothing. . 2 where τ is the time to maturity of the futures contract. • Swap rates are inappropriately interpolated. . . An example is 1 forward rate = futures rate − σ 2 τ 2 . at S5 = 11/4/96) are ignored once P (t0 .

The spot date is 4/9/96. Table 4. pn ). . .2: Market prices for UK gilts.49 13/10/08 110.426): UK government bond (gilt) market.25 9 7 9.28 06/11/01 101. . 1996. 4/9/96. The coupon payments are semiannual.2.75 12.4. T1 = 26/09/96. .2. .04 26/03/99 118.5 7. T2 = 13/10/96. • bond i with cashflows (coupon and principal payments) ci. GENERAL CASE 45 4.82 19/01/98 106.24 08/09/06 98.44 03/03/00 106.1 Data: Bond Markets • vector of quoted/market bond prices p = (p1 . .75 9 next coupon 15/11/96 19/01/97 26/09/96 03/03/97 06/11/96 27/02/97 07/12/96 08/03/97 13/10/96 maturity dirty price date (pi ) 15/11/96 103. . 1≤j≤N Example (→ JW[11].j ) 1≤i≤n .15 27/08/02 111. .87 bond bond bond bond bond bond bond bond bond 1 2 3 4 5 6 7 8 9 Hence n = 9 and N = 1 + 3 + 6 + 7 + 11 + 12 + 19 + 20 + 25 = 104. coupon (%) 10 9. and the day-count convention is actual/365.j at time Tj (may be zero). T3 = 06/11/97. • dates of all cashflows t0 < T1 < · · · < TN . selection of nine gilts. . forming the n × N cashflow matrix C = (ci.06 07/12/05 106. p. September 4.75 8.

Swap (receiver.  0 3.. c0 = −1... ESTIMATING THE YIELD CURVE is  No bonds have cashflows at the same date.125 0 0 0 0 0 0 0 0 6. .875 0 0 0 0 .125 . • if T0 > t0 : p = 0. The spot date t0 is 8/10/97. p.   0 0 0 0 0 0 0 0 3. FRA (forward rate F for [T.875 0 .  0 0 0 0 0 4.. cn = 1 + δK. Example (→ JW[11]. c2 = 1+(S−T )F at T2 = S.... c1 = −1 at T1 = T . . FRAs and forward swaps have notional price 0. maturity T ): p = 1 and c = 1 + (T − t0 )L at T .5 0 0 0 0 0 0 0 0 . LIBOR is for o/n (1/365).   6. The 9 × 104 cashflow matrix  0 0 0 105 0 0 0 0 0 0 ...25 0 0 0 0 0 .875 0 0 0 .   0 0 0 0 4..2. S]): p = 0. C= 0   0 0 0 0 0 0 4.46 CHAPTER 4..5 0 0 .. c1 = · · · = cn−1 = δK. cn = 1 + δK.5 0 0 0 0 0 0 0 .              4. 0 4.2 Money Markets Money market data can be put into the same price–cashflow form as above. tenor t0 ≤ T0 < · · · < Tn . 1m (33/360).. • if T0 = t0 : p = 1. and 3m (92/360).. Ti − Ti−1 ≡ δ): since n 0 = −D(T0 − t0 ) + δK j=1 D(Tj − t0 ) + (1 + δK)D(Tn − t0 ). 1997. c1 = · · · = cn−1 = δK. . swap rate K. LIBOR (rate L.. The day-count convention is Actual/360.428): US money market on October 6. → at t0 : LIBOR and swaps have notional price 1..   0 0 0 0 0 0 0 4.

GENERAL CASE 47 Futures are three month rates (δ = 91/360).59375 9/10/97 5.3: US money market. T1 = 9/10/97.16 6.18 17/6/98 94.12 16/9/98 94 16/12/98 6.01253 6.32 6. T. We take them as forward rates. . . T3 = 10/11/97. Table 4. T + δ)).625 10/11/97 5.4. The first payment date is 8/10/98. The first 14 columns of .22 6.56 6. October 6.26 19/11/97 94. T2 = 15/10/97 (first future).71875 8/1/98 94. N = 3 + 14 + 30 = 47. Swaps are annual (δ = 1). .10823 6. . the quote of the futures contract with maturity date (settlement day) T is 100(1 − F (t0 .24 17/12/97 94. LIBOR Period o/n 1m 3m Oct-97 Nov-97 Dec-97 Mar-98 Jun-98 Sep-98 Dec-98 2 3 4 5 7 10 15 20 30 Rate Maturity Date 5.2. 1997.23 18/3/98 94.27 15/10/97 94.56 6.42 6. That is.56 Futures Swaps Here n = 3 + 7 + 9 = 19.

01461. c16. c47 = 1. we have n N .12 c19. c15.060125.01451.12 c17.0616.12 = 0.01471.01486. c8. c17. c69 = 1.12 = 0.48 CHAPTER 4.01456.12 c12. c10.12 c14. ESTIMATING THE YIELD CURVE the 19 × 47 cashflow matrix C are c11 0 0 0 0 0 0 0 0 0 0 0 0 c23 0 0 0 0 0 0 0 0 0 0 0 0 0 c36 0 0 0 0 0 0 −1 0 0 0 0 c47 0 0 0 0 0 0 0 −1 0 0 0 c58 0 0 0 0 0 0 0 −1 0 0 0 c69 0 0 0 0 0 0 0 0 0 −1 c7.0642. c13.10 0 0 0 0 0 0 0 0 0 0 0 −1 c8.12 = 0.12 c16.13 −1 c10. many entries of C are zero (different cashflow dates). c12.13 = 1.12 = c18. c36 = 1. c7.00516. 0 0 0 0 0 0 0 0 0 0 c11.01448.01459.00016.12 c18.2. .11 = 1. This makes ordinary least square (OLS) regression d∈RN min { 2 | = p − C · d} (⇒ C T p = C T Cd∗ ) unfeasible.12 = 0.0622. c14.12 c13.14 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 4.0632. c58 = 1. c23 = 1.12 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 c9. c9.12 = 0.11 0 0 0 0 0 0 0 0 0 0 −1 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 with c11 = 1.061082.3 Problems Typically.14 = 1.10 = 1.12 = 0.0656.01517 c11.12 c15.12 = 0. Moreover.12 = c19.

z) du . ψm (preferably with compact support). Linear Families Fix a set of basis functions ψ1 . GENERAL CASE 49 One could chose the data set such that cashflows are at same points in time (say four dates each year) and the cashflow matrix C is not entirely full of zeros (Carleton–Cooper (1976)). For regularity reasons (see below) it is best to estimate the forward curve R+ x → f (t0 . z) = z1 ψ1 (x) + · · · + zm ψm (x). z). and even worse for forward rates. t0 + x) = φ(x) = φ(x. z) du for some payment tenor 0 < x1 < · · · < xN . But there is nothing to regularize the discount factors (discount factors of similar maturity can be very different). z) = exp − φ(u. . This leads to a nonlinear optimization problem min p − C · d(z) . . 4. . 0 z ∈ Z. As a result this leads to a ragged spot rate (yield) curve. .4 Parametrized Curve Families Reduction of parameters and smooth yield curves can be achieved by using parametrized families of smooth curves x D(x) = D(x. with state space Z ⊂ Rm .4. . and let φ(x. z∈Z with di (z) = exp − 0 xi φ(u.2. Still regression only yields values D(xi ) at the payment dates t0 + xi → interpolation technics necessary.2.

04 0. . bm−1 } (a kth degree spline has m + k parameters). Introduce six extra knot points ξ−3 < ξ−2 < ξ−1 < ξ0 < · · · < ξm < ξm+1 < ξm+2 < ξm+3 . . It interpolates values at m + 1 knot points ξ0 < · · · < ξm . . ξm ] is given by the m + 3 B-splines k+4 k+4 ψk (x) = j=k i=k. The spline is uniquely characterized by specification of σ or σ at ξ0 and ξm .03 0. The B-spline ψk is zero outside [ξk . ESTIMATING THE YIELD CURVE Cubic B-splines A cubic spline is a piecewise cubic polynomial that is everywhere twice differentiable. + hence it has m + 3 parameters {a0 . A basis for the cubic splines on [ξ0 . . b1 . .01 2 4 6 8 10 12 . . m − 1. ξk+4 ].02 0. .05 0. . 8. 1. 11}.50 CHAPTER 4.4: B-spline with knot points {0. Its general form is 3 m−1 σ(x) = i=0 a i xi + j=1 bj (x − ξj )3 . a4 . + k = −3. 6. .i=j 1 ξi − ξ j (x − ξj )3 . 0.06 0. . . . Figure 4.

11.822 1 log =− log 0. z) = ψ1 (0)z1 + · · · + ψm (0)zm = 1. the unique unconstrained solution is z ∗ = (AT A)−1 AT p.2. 72 105 0. 25.  . The maximum time to maturity. The estimation with all 8 B-splines leads to z∈R8 min p − CΨz = p − CΨz ∗ = 0. ψ1 (xN ) · · · ψm (xN ) D(xN . zm this leads to the linear optimization problem z∈Rm If the n × m matrix A := CΨ has full rank m.4. d(z) =  · = .  =: Ψ · z .23 . Example We take the UK government bond market data from the last section (Table 4.989 = 0.  . . z) = z1 ψ1 (x) + · · · + zm ψm (x). . 20. . A reasonable constraint would be D(0. 15. z)     . −5. is 12. .0572. first 7) B-splines with the 12 knot points {−20. With     ψ1 (x1 ) · · · ψm (x1 ) D(x1 . 30} (see Figure 4. 8. 0. D(x. x104 .5).  z1 .11 [years]. GENERAL CASE 51 Estimating the Discount Function B-splines can also be used to estimate the discount function directly (Steeley (1991)). 1. 6. . . Its exact yield is y=− 365 103.197 • As a basis we use the 8 (resp. z)  min p − CΨz .2). Notice that the first bond is a zero-coupon bond. −2.

04 0.074      .8019 11.57992 7. 3-monthly forward rates) shown in Figure 4. 11. 0.05 0.49629 7.28853 5.     with . 8.52 CHAPTER 4. 30}.01 5 10 15 20 25 30 with and the discount function.7.98066 6.8641 11.56562 7.07 0. The estimation with only the first 7 B-splines leads to z∈R7      ∗ z =       13.38766 4. ESTIMATING THE YIELD CURVE Figure 4.9919      . and forward curve (cont.03 0.5: B-splines with knots {−20. −2.9717 855. spot rates).       min p − CΨz = p − CΨz ∗ = 0. 0. 1.06 0.4665 8. 15.02 0. comp. comp.69741 6.32     ∗ z =      17. 6. 25.23383 −4. yield curve (cont.3603 8. −5. 20.

4. Figure 4.005 5 10 15 20 25 30 The estimation with this 5 B-splines leads to z∈R min p − CΨz = p − CΨz ∗ = 0.8. and forward curve (cont.03 0. −5. 20.02 0. 0. • Next we use only 5 B-splines with the 9 knot points {−10. 30}. 4. 25.025 0.015 0.40296 6.2. GENERAL CASE 53 and the discount function. yield curve (cont. 20.9886 7.4. −5. comp. yield curve (cont.6: Five B-splines with knot points {−10. 0. 25. and forward curve (cont.9.4385 12. comp. 3-month forward rates) shown in Figure 4.   .23152  with ∗ and the discount function. 15. spot rates). −2. comp.652 19.035 0.6).39 5  15.01 0. −2. spot rates). 15. 0. 30} (see Figure 4. 3-monthly forward rates) shown in Figure 4.   z =     . comp.

2 0.06 0.15 0. ESTIMATING THE YIELD CURVE Figure 4.04 0.14 0.2 2 0. 1 0.1 0.02 2 0.6 0. yield and forward curves for estimation with 8 B-splines.54 CHAPTER 4.25 0.05 2 4 6 8 10 12 4 6 8 10 12 4 6 8 10 12 .8 0.1 0. The dot is the exact yield of the first bond.12 0.7: Discount function.4 0.08 0.

2. 1 0.06 0.2 0.2 2 0.6 0.1 0.08 0.02 2 0.4 0.1 0.15 0.14 0.8: Discount function.25 0.4.8 0. GENERAL CASE 55 Figure 4. The dot is the exact yield of the first bond.12 0.05 2 4 6 8 10 12 4 6 8 10 12 4 6 8 10 12 .04 0. yield and forward curves for estimation with 7 B-splines.

25 0.06 0. The dot is the exact yield of the first bond. yield and forward curves for estimation with 5 B-splines.02 2 0.14 0.1 0. ESTIMATING THE YIELD CURVE Figure 4.2 2 0.05 2 4 6 8 10 12 4 6 8 10 12 4 6 8 10 12 .4 0. 1 0.04 0.15 0.1 0.9: Discount function.56 CHAPTER 4.2 0.12 0.8 0.08 0.6 0.

9 are more regular than those in Figure 4. . GENERAL CASE Discussion • In general. • The B-spline fits are extremely sensitive to the number and location of the knot points. P (0. . P (0. but their correctness criteria (0. → Smoothing splines.39) are worse than for the fit with 8 B-splines (0. → Direct estimation of the yield or forward curve. . Ti ) = exp(−Ti Yi ). splines can produce bad fits. .2. T1 ).23). → Optimal selection of number and location of knot points for splines. .4. → Need criterions asserting smooth yield and forward curves that do not fluctuate too much and flatten towards the long end. • There is a trade-off between the quality (or regularity) and the correctness of the fit. 57 • Estimating the discount function leads to unstable and non-smooth yield and forward curves. Problems mostly at short and long term maturities. . Sabine Lorimier suggests a spline method where the number and location of the knots are determined by the observed data itself. Smoothing Splines The least squares criterion min p − C · d(z) z 2 has to be replaced/extended by criterions for the smoothness of the yield or forward curve. In her PhD thesis 1995. and consequently the N yields Y1 . . Y N .32 and 0. The curves in Figures 4.8 and 4. Example: Lorimier (95). For ease of notation we set t0 = 0 (today). TN ) at 0 < T1 < · · · < TN ≡ T . . The data is given by N observed zero-coupon bonds P (0. . • Splines are not useful for extrapolating to long term maturities.7.

0 Introduce the Sobolev space H = {g | g ∈ L2 [0. T ] is a second order polynomial on [0. The fitting requirement now is for the forward curve Ti √ f (u) du + i / α = Ti Yi . f ∈H (*) The parameter α tunes the trade-off between smoothness and correctness of the fit. Tk ] with hk (u) = (Tk − u)+ . . k = 1. and the nonlinear functional on H T N F (f ) := 0 (f (u)) du + α i=1 2 Ti 2 Yi Ti − f (u) du 0 . Problem (*) has a unique solution f . . .3) where hk ∈ C 1 [0. which is a second order spline characterized by N f (u) = f (0) + k=1 ak hk (u) (4.58 CHAPTER 4. (4. N.4) . The optimization problem then is min F (f ). ESTIMATING THE YIELD CURVE Let f (u) denote the forward curve. The aim is to minimize smoothness criterion T 2 as well as the (4. h H = g(0)h(0) + 0 g (u)h (u) du.1) 0 with an arbitrary constant α > 0. T ]} with scalar product T g. hk (0) = Tk . (4. .2.1.2) (f (u))2 du. Theorem 4.

hk 0 H. .2. g for all g ∈ H. hk T H = 0 we obtain f − f (0). . . g Hence H = 0 f (u)g (u) du = 0. f − f (0) ∈ span{h1 .6) α Yk Tk − f (0)Tk − a l h l . k=1 N (4. hN } . Tk hl du = hl . Integration by parts yields Tk 0 Tk g(u) du = Tk g(Tk ) − = Tk g(0) + Tk ug (u) du 0 Tk 0 T Tk g (u) du − ug (u) du 0 H. .5) k = 1. hk l=1 H = ak . N.4. A (local) minimizer f of F satisfies d F (f + g)| =0 = 0 d or equivalently T N Tk Tk f g du = α 0 k=1 Yk Tk − f du 0 0 g du. . (4. . GENERAL CASE and f (0) and ak solve the linear system of equations N 59 ak Tk = 0. ∀g ∈ H. Proof. In particular. . = Tk g(0) + 0 (Tk − u)+ g (u) du = hk . for all g ∈ H with g. . (4.7) In particular.

6) has a unique solution (f (0). that the linear system (4. . Next we show that (4. . . Thus we have shown that (4. λN )T ∈ RN +1 such that Aλ = 0. Hence we have T N Tk N Tk f (u)g (u) du = 0 k=1 ak −Tk g(0) + g(u) du = 0 k=1 ak 0 g(u) du.8) . h2 H · · · α h 1 .5)–(4. . h1 H + 1 α h1 . hk l=1 H 0 g(u) du = 0 for all g ∈ H. .60 CHAPTER 4. .4) and (4. that is. where we used (4. . . . then T N F (g) = 0 (4. . αTN α h N . hN H + 1 N Let λ = (λ0 . and (4.7) with g − f ∈ H. . . N.. k = 1. .6) holds. .6).3).7) is a sufficient condition for f to be a global minimizer of F . The corresponding (N + 1) × (N + 1) matrix is   0 T1 T2 ··· TN  αT1 α h1 .3)–(4. . .  . .5) (set u = 0). hN H    A= . ESTIMATING THE YIELD CURVE what proves (4. (4. h1 H α h N . that is. . aN ).7) can be rewritten as N N Tk k=1 ak − α Yk Tk − f (0)Tk − a l h l .. This is true if and only if (4. It remains to show that f exists and is unique. .   . h2 H · · · α h N . . Tk λk = 0 k=1 N αTk λ0 + α l=1 h k .7) ((g − f ) + f ) du + α T 2 0 2 Tk 2 k=1 N Yk Tk − Tk 0 g du 0 Tk 2 = F (f ) + (g − f ) du + α k=1 f du − g du 0 ≥ F (f ). . a1 . hl H λl + λk = 0. . Let g ∈ H. (4. .7) is equivalent to (4.

YN )T —one has to solve the linear system A· f (0) a = 0 Y (see (4. . (f )2 du + α log pk − log ckl exp − min f ∈H  0  0 k=1 l=1 If the coupon payments are small compared to the nominal (=1).9) a perfect fit. maximal regularity T (f (u))2 du = 0 0 but no fitting of data. n. . .1). . . . k = 1. 0 k = 1. • If α → ∞ then (4. then the above method has to be modified and becomes nonlinear. f minimizes (4. . N. this reads   2 n N   T Tl f du . . . if coupon bond prices are given. N .9).7) implies that Tk f (u) du = Yk Tk . . . With p ∈ Rn denoting the market price vector and ckl the cashflows at dates Tl . (4. whence A is non-singular. GENERAL CASE Multiplying the latter equation with λk and summing up yields N 2 N 61 α k=1 λ k hk H + k=1 λ2 = 0. see (4. . a constant function. . . That is.3) and (4. To estimate the forward curve from N zero-coupon bonds—that is. That is. . Of course. . then this problem has a unique solution.8)). yields Y = (Y1 .2) subject to the constraints (4.4.6) we have f (u) ≡ f (0). This and much more is carried out in Lorimier’s thesis. k Hence λ = 0. l = 1. The role of α is as follows: • If α → 0 then by (4.2. .

4 is taken from a document of the Bank for International Settlements (BIS) 1999 [2]. 8 6 4 2 5 10 15 20 Table 4. O. . . . ESTIMATING THE YIELD CURVE Exponential-Polynomial Families Exponential-polynomial functions p1 (x)e−α1 x + · · · + pn (x)e−αn x (pi =polynomial of degree ni ) form non-linear families of functions.22. .10: Nelson–Siegel curves for z1 = 7. −3.62 CHAPTER 4. including 6 parameters z1 . z6 .19. .2. E. . z4 and φN S (x.77. Princeton University) This is an extension of Nelson–Siegel.21. . Figure 4.76. z4 = 0. −2. z2 = −4. −4. −1. . z) = z1 + (z2 + z3 x)e−z4 x . Svensson (94) [26] (Prof. L. −0. . Svensson is at the Economics Department. z) = z1 + (z2 + z3 x)e−z4 x + z5 e−z6 x .5 and 7 different values for z3 = 1.69. 0. Popular examples are: Nelson–Siegel (87) [20] There are 4 parameters z1 .13.18. φS (x.

2. Central Bank Belgium Canada Finland France Germany Italy Japan Norway Spain Sweden UK USA Method S or NS S NS S or NS S NS smoothing splines S S S S smoothing splines Minimized Error wp sp wp wp yields wp prices yields wp yields yields bills: wp bonds: prices Criteria for Curve Families • Flexibility (do the curves fit a wide range of term structures?) • Number of factors not too large (curse of dimensionality). . GENERAL CASE 63 Table 4. BIS 1999 [2]. S for Svensson.4. NS is for Nelson–Siegel. • Regularity (smooth yield or forward curves that flatten out towards the long end). • Consistency: do the curve families go well with interest rate models? → this point will be exploited in the sequel.4: Overview of estimation procedures by several central banks. wp for weighted prices.

64 CHAPTER 4. ESTIMATING THE YIELD CURVE .

where n may be 20 (e. PCA). → Need strong structure to be imposed on the co-movements of financial quantities of interest. → Simultaneous pricing of different options and hedging instruments in a consistent framework. a 10y swap with semi-annual payments) or more. → Specify the dynamics of a small number of variables (e. But: the payoffs even of “plain-vanilla” fixed income products such as caps. .Chapter 5 Why Yield Curve Models? → R[22](Chapter 5) Why modelling the entire term structure of interest rates? There is no need when pricing a single European call option on a bond. 65 . . swaptions consist of a sequence of cashflows at T1 . This is exactly what interest rate (curve) models offer: • reduction of fitting degrees of freedom → makes problem manageable.g. =⇒ It is practically and intellectually rewarding to consider no-arbitrage conditions in much broader generality. . Tn . Historical estimation of such large covariance matrices is statistically not tractable anymore. . floors.g. → The valuation of such products requires the modelling of the entire covariance structure. → Correlation structure among observable quantities can now be obtained analytically or numerically.

WHY YIELD CURVE MODELS? .66 CHAPTER 5.

. . following strictly positive Itˆ processes o d dSi (t) = Si (t)µi (t) dt + j=1 Si (t)σij (t) dWj (t). Reference is B[3]. Wd ). . This is not a restriction since always one can set a stochastic process to be zero after a finite time T if this were the ultimate time horizon (as in the Black–Scholes model). [23]. . 6. . . [25]. n and the risk-free asset dS0 (t) = r(t)S0 (t) dt.1 Self-Financing Portfolios The stochastic basis is a probability space (Ω. Financial Market We consider a financial market with n traded assets. S0 (0) = 1 67 ⇔ S0 (t) = e t 0 r(s) ds . and the filtration (Ft )t≥0 generated by W . P).Chapter 6 No-Arbitrage Pricing This chapter briefly recalls the basics about pricing and hedging in a Brownian motion driven market. The background for stochastic analysis can be found in many textbooks. F . a d-dimensional Brownian motion W = (W1 . etc. and many more. We shall assume that F = F∞ = ∨t≥0 Ft . MR[19](Chapter 10). and do not a priori fix a finite time horizon. such as [14]. From time to time we recall some of the fundamental results without proof. i = 1. Si > 0. . . .

Theorem 6. Remark 6. etc.68 CHAPTER 6. . Its corresponding value process is n V (t) = V (t. n . hd ) be a measurable adapted process.” (that is. φ) := i=0 φi (t)Si (t). The portfolio φ is called self-financing (for S) if the stochastic integrals t φi (u) dSi (u).1. is any adapted process φ = (φ0 . . NO-ARBITRAGE PRICING The drift µ = (µ1 . φn ). . Let h = (h1 . . It is always understood that for a random variable “X ≥ 0” means “X ≥ 0 a. and short rates r are assumed to form adapted processes which meet the required integrability conditions such that all of the above (stochastic) integrals are well-defined. . .1. . . .1. . µn ). . . or trading strategy. P[X ≥ 0] = 1). 0 i = 0.s. . Self-financing Portfolios A portfolio.2 (Stochastic Integrals). . If t h(s) 0 2 ds < ∞ for all t > 0 (the class of such processes is denoted by L) one can define the stochastic integral t d t (h · W )t ≡ If moreover 0 h(s) dW (s) ≡ ∞ 0 hj (s) dWj (s). volatility σ = (σij ). . j=1 0 E h(s) 2 ds < ∞ (the class of such processes is denoted by L2 ) then h · W is a martingale and the Itˆ isometry holds o t 2 t E h(s) dW (s) 0 =E h(s) 0 2 ds . .

6.2. ARBITRAGE AND MARTINGALE MEASURES are well defined and dV (t; φ) =
i=0 n

69

φi (t) dSi (t).

Numeraires All prices are interpreted as being given in terms of a numeraire, which typically is a local currency such as US dollars. But we may and will express from time to time the prices in terms of other numeraires, such as Sp for some 0 ≤ p ≤ n. The discounted price process vector Z(t) := implies the discounted value process
n

S(t) Sp (t)

˜ V (t; φ) :=
i=0

φi (t)Zi (t) =

V (t; φ) . Sp (t)

Up to integrability, the self-financing property does not depend on the choice of the numeraire. Lemma 6.1.3. Suppose that a portfolio φ satisfies the integrability conditions for S and Z. Then φ is self-financing for S if and only if it is self-financing for Z, in particular
n n

˜ dV (t; φ) =
i=0

φi (t) dZi (t) =
i=0 i=p

φi (t) dZi (t).

(6.1)

Since Zp is constant, the number of terms in (6.1) reduces to n. Often (but not always) we chose S0 as the numeraire.

6.2

Arbitrage and Martingale Measures

Contingent Claims Related to any option (such as a cap, floor, swaption, etc) is an uncertain future payoff, say at date T , hence an FT -measurable random variable X (a contingent (T -)claim). Two main problems now are: • What is a “fair” price for a contingent claim X? • How can one hedge against the financial risk involved in trading contingent claims?

70

CHAPTER 6. NO-ARBITRAGE PRICING

Arbitrage An arbitrage portfolio is a self-financing portfolio φ with value process satisfying V (0) = 0 and V (T ) ≥ 0 and P[V (T ) > 0] > 0 for some T > 0. If no arbitrage portfolios exist for any T > 0 we say the model is arbitrage-free. An example of arbitrage is the following. Lemma 6.2.1. Suppose there exists a self-financing portfolio with value process dU (t) = k(t)U (t) dt, for some measurable adapted process k. If the market is arbitrage-free then necessarily r = k, dt ⊗ dP-a.s. Proof. Indeed, after discounting with S0 we obtain U (t) ˜ = U (0) exp U (t) := S0 (t) Then (→ exercise) ψ(t) := 1{k(t)>r(t)} yields a self-financing strategy with discounted value process ˜ V (t) =
0 t t 0 t 0

(k(s) − r(s)) ds .

˜ ψ(s) dU(s) =

˜ 1{k(s)>r(s)} (k(s) − r(s))U (s) ds ≥ 0.

Hence absence of arbitrage requires ˜ 0 = E[V (T )] = ˜ 1{k(t,ω)>r(t,ω)} (k(t, ω) − r(t, ω))U (t, ω) dt ⊗ dP
>0 on N

N

where N := {(t, ω) | k(t, ω) > r(t, ω)} is a measurable subset of [0, T ] × Ω. But this can only hold if N is a dt ⊗ dPnullset. Using the same arguments with changed signs proves the lemma.

6.2. ARBITRAGE AND MARTINGALE MEASURES

71

Martingale Measures We now investigate when a given model is arbitrage-free. To simplify things in the sequel • we fix S0 as a numeraire, and ˜ • V will express the discounted value process V /S0 . But the following can be made valid for any choice of numeraire. An equivalent probability measure Q ∼ P is called an equivalent (local) martingale measure (E(L)MM) if the discounted price processes Zi = Si /S0 are Q-(local) martingales. Theorem 6.2.2 (Girsanov’s Change of Measure Theorem). Let Q ∼ P be an equivalent probability measure. Then there exists γ ∈ L such that the density process dQ/dP is the stochastic exponential E(γ · W ) of γ · W dQ |F = Et (γ · W ) := exp dP t Moreover, the process ˜ W (t) := W (t) −
t t 0

1 γ(s) dW (s) − 2

t

γ(s)
0

2

ds .

(6.2)

γ(s) ds
0

(6.3)

is a Q-Brownian motion. Conversely, if γ ∈ L is such that E (γ · W ) is a uniformly integrable martingale with E∞ (γ · W ) > 0 — sufficient is the Novikov condition E exp 1 2
∞ 0

γ(s)

2

ds

<∞

(6.4)

(see [23, Proposition (1.26), Chapter IV]) — then (6.2) defines an equivalent probability measure Q ∼ P. Market Price of Risk Let Q be an ELMM and γ (the stochastic logarithm ˜ of the density process) and W given by (6.2) and (6.3). Integration by parts yields the Z-dynamics dZi (t) = Zi (t) (µi (t) − r(t)) dt + Zi (t)σi (t) dW (t) ˜ = Zi (t) (µi (t) − r(t) + σi (t) · γ(t)) dt + Zi (t)σi (t) dW (t).

“suicide strategies” remain (however.g. . This would certainly be a money-making machine. . M (0) = 1 and M (1) = 0) can be constructed. Notice that. Zi can be written as stochastic exponential o ˜ Zi = E(σi · W ). For example it is possible to construct a local martingale M with M (0) = 0 and M (1) = 1. In the same way “suicide strategies” (e. NO-ARBITRAGE PRICING If σ is non-degenerate (in particular d ≤ n and rank[σ] = d) then γ is uniquely specified by −γ = σ −1 · (µ − r1) µi − r + σi · γ = 0 dt ⊗ dQ-a. . for all i = 1.s. . φ) is a true Q-martingale. 1)T . Admissible Strategies In the presence of local martingales one has to be alert to pitfalls.72 Hence necessarily γ satisfies CHAPTER 6. If γ is unique then Q is the unique ELMM. Conversely. say arbitrage. There are several ways to do so. . which looks like the (discounted) value process of a self-financing strategy.4) is sufficient) then (6. are sensitive with respect to the choice of numeraire! .5) has a solution γ ∈ L such that E(γ · W ) is a uniformly integrable martingale (the Novikov condition (6. if (6. Here are two typical examples: A self-financing strategy φ is admissible if ˜ 1. (6. however. φ) is a Q-supermartingale for every ELMM Q. n.5) Hence if σi satisfies the Novikov condition (6. φ) ≥ −a for some a ∈ R. by Itˆ’s formula. V (t. φ(s) dW (s) (Dudley’s Representation Theorem). . Both conditions 1 and 2. . and vice versa. .4) for all i = 1.2) defines an ELMM Q. Even worse. M can be chosen to be of the form t M (t) = 0 where 1 := (1. . OR ˜ 2. . To rule out such examples we have to impose additional constraints on the choice of strategies. for some ELMM Q. . they do not introduce arbitrage). n then the ELMM Q is in fact an EMM. V (t. Yet. This is why −γ is called the market price of risk . Condition 1 is more universal (it does not depend on a particular Q) and implies that V (t. .

It has become a custom (and we will follow this tradition) to consider the existence of an ELMM as synonym for the absence of arbitrage: absence of arbitrage = existence of an ELMM. Suppose there exists an ELMM Q.3. let V be the discounted value process of an admissible strat˜ ˜ ˜ egy. → the existence of an ELMM is now a standing assumption. then its absence implies the existence of an ELMM Q. Then the contingent claim X = 1 due at T is attainable by an obvious buy and hold strategy with value process V (t) = S1 (t). Lemma 6. Since V is a Q-supermartingale in any case (for some ELMM Q). . in the sense that there exists no admissible (either Condition 1 or 2) arbitrage strategy.2.6.3 Hedging and Pricing Attainable Claims A contingent claim X due at T is attainable if the exists an admissible strategy φ which replicates/hedges X. ˜ whence V (T ) = 0.3. ˜ Proof. etc) that also the converse holds true: if arbitrage is defined in the right way (“No Free Lunch with Vanishing Risk”). Then the model is arbitrage-free. Indeed. A simple example: suppose S1 is the price process of the T -bond. It is folklore (Delbaen and Schachermayer 1994. V (T . φ) = X. with V (0) = 0 and V (T ) ≥ 0. HEDGING AND PRICING 73 The Fundamental Theorem of Asset Pricing The existence of an ELMM rules out arbitrage. This is called the Fundamental Theorem of Asset Pricing. we have ˜ ˜ 0 ≤ EQ [V (T )] ≤ V (0) = 0. 6. that is.

Suppose that σ is non-degenerate. Lemma 6. Define the Q-martingale Y (t) := EQ [X/S0 (T ) | Ft ] .5) yields a uniformly integrable martingale E(γ · W ) and hence a unique ELMM Q.3.3 we can find ψ ∈ L such that t Y (t)D(t) = D(t)EQ [Y (T ) | Ft ] = E[Y (T )D(T ) | Ft ]. 1 1 1 + d(Y D) + d Y D.6) and that the unique market price of risk −γ given by (6. with the density process D(t) = dQ/dP|Ft = Et (γ · W ).74 CHAPTER 6. NO-ARBITRAGE PRICING Complete Markets The main problem is to determine which claims are attainable. Y (t)D(t) = Y (0) + 0 ψ(s) dW (s). Applying Itˆ’s formula yields o d and dY = d (Y D) = = 1 D = YDd dW − ˜ dW . T ].7) is attainable.3. This is most conveniently carried out in terms of discounted prices. 1 ψ−Yγ D 1 ψ−Yγ D ˜ =:ψ . that is d ≤ n and rank[σ] = d. (6. Then the model is complete in the sense that any contingent claim X with X/S0 (T ) ∈ L1 (FT . Q) (6.1. Proof. Hence Y D is a Pmartingale and by the representation theorem 6. D D D 1 ψ − Y γ · γ dt D 1 D =− 1 1 γ dW + γ D D 2 dt. Then Bayes t ∈ [0.

there exists a unique ELMM Q. Zi (6.9) ˜ V (t. φ) = Y (T ) = EQ [X/S0 (T )] + i=1 T φi (s) dZi(s) = X/S0 (T ).6). However.6) and (6. These conditions are in fact equivalent (see for example MR[19](Chapter 10)).3.) Pricing In the above complete model the fair price prevailing at t ≤ T of a T -claim X which satisfies (6. models can be generically incomplete (as real markets are).3 (Representation Theorem). φ) = S0 (t)V (t. Hence φ yields an admissible strategy with discounted value process satisfying n ˜ V (T . The literature on incomplete markets is huge.7) is given by (6. HEDGING AND PRICING Now define φi = then it follows that n n 75 ˜ ((σ −1 )T ψ)i . 3. 2.8) φi dZi = i=1 i=1 ˜ ˜ ˜ ˜ ˜ ˜ ˜ φi Zi σi dW = (σ −1 )T ψ · σ dW = ψ · σ −1 σ dW = ψ dW = dY.3. and the topic beyond the scope of this course. (6. The following are equivalent: 1.8)) implies uniqueness of Q and completeness of the model.9) 0 Hence non-degeneracy of σ (see (6. φ) = S0 (t)EQ [X/S0 (T ) | Ft ] . (This theorem requires the filtration (Ft ) to be generated by W . σ is non-degenerate.10) We shall often encounter complete models.3. Theorem 6. .2 (Completeness).6. see (6. (6. Every P-local martingale M has a continuous version and there exists ψ ∈ L such that t M (t) = M (0) + 0 ψ(s) dW (s). the model is complete. Theorem 6. and then the pricing becomes a difficult issue.

7) according to (6. π(t) E X dQ | S0 (T ) dP FT dQ | dP Ft 1 dQ |F . This is why π is called the state-price density process.g.76 CHAPTER 6. This is a consistent pricing rule in the sense that the enlarged market Y. The price of a T -bond for example is (if 1/S0 (T ) ∈ L1 (Q). . . S0 . T ) = E π(T ) S0 (t) | Ft = E Q | Ft . for the price at t = 0 Y (0) = E[Xπ(T )]. . π(t) S0 (T ) Also one can check (→ exercise) that if Q is an EMM then Si π are P-martingales. . → exercise) P (t. the market price of risk) and then price a T -claim X satisfying (6. . in particular. for short rate models) to exogenously specify a particular ELMM Q (or equivalently. Sn is still arbitrage-free (why?). NO-ARBITRAGE PRICING State-price Density It is a custom (e. S0 (t) dP t | Ft and.10) price of X at t =: Y (t) = S0 (t)EQ [X/S0 (T ) | Ft ] . Now define π(t) := By Bayes formula we then have Y (t) = S0 (t)EQ [X/S0 (T ) | Ft ] = S0 (t) = E [Xπ(T ) | Ft ] .

MR[19](Chapter 12). We assume that • the short rates follow an Itˆ process o dr(t) = b(t) dt + σ(t) dW (t) determining the savings account B(t) = exp t 0 r(s) ds . • all zero-coupon bond prices (P (t. B(t) is a Q-martingale for all T > 0.T ] are adapted processes (with P (T. such that P (t. P). The filtration (Ft )t≥0 is generated by a d-dimensional Brownian motion W . • no-arbitrage: there exists an EMM Q. T ]. etc 7.1 Generalities Short rate models are the classical interest rate models. T ) . where P is considered as objective probability measure. T ) = 1 as usual). As in the last section we fix a stochastic basis (Ω. F . 77 t ∈ [0. .Chapter 7 Short Rate Models → B[3](Chapters 16–17). T ))t∈[0.

2) Moreover. P (t. T ) ˜ = P (0. Let −γ denote the corresponding market price of risk dQ |F Et (γ · W ) = dP t ˜ and W = W − γ dt the implied Q-Brownian motion.1). T ) = (r(t) − γ(t) · σ γ (t. T ]. T )) dt + σ γ dW (t). T ). the existence of an ELMM for all T -bonds excludes arbitrage among every finite selection of zero-coupon bonds. B(t) Proof.3) and hence P (t.1. . This can be done (see [4] or Mike Tehranchi’s PhD thesis 2002) but is beyond the scope of this course. Exercise (proceed as in the Completeness Lemma 6. SHORT RATE MODELS According to the last chapter. Tn ). . the process r satisfies under Q ˜ dr(t) = (b(t) + σ(t) · γ(t)) dt + σ(t) dW (t). t ∈ [0. To be more general one would have to consider strategies involving a continuum of bonds. Under the above assumptions.1. (7. such that dP (t. For convenience we require Q to be an EMM (and not merely an ELMM) because then we have P (t. T ) ˜ = r(t) dt + σ γ (t. It follows from (7. T )Et σ γ · W . T ) This illustrates again the role of the market price of risk −γ as the excess of instantaneous return over r(t) in units of volatility. P (t.3) that the T -bond price satisfies under the objective probability measure P dP (t. Proposition 7. .78 CHAPTER 7. for any T > 0 there exists an adapted Rd -valued process σ γ (t. . T ) (7. . say P (t. T ) dW (t) P (t. T ) = EQ e− T t r(s) ds | Ft (7. T1 ).3.1) (compare this to the last section).

DIFFUSION SHORT RATE MODELS 79 In a general equilibrium framework. where now Q is considered as martingale measure. r(t)) dt + σ(t. According to the Completeness Theorem 6.2 Diffusion Short Rate Models We fix a stochastic basis (Ω. Ingersoll and Ross (85) [7]). Since our arguments refer only to the absence of arbitrage between primary securities (bonds) and derivatives. F . r(u)) du + 0 σ(u. see also (7. Let Z ⊂ R be a closed interval.4) admits a unique Z-valued solution r = r ρ with t t r(t) = ρ + 0 b(u.7. A priori. Q).5) .1). 7. and hence the savings account B(t). the market price of risk is given endogenously (as it is carried out in the seminal paper by Cox. Q can be any equivalent probability measure Q ∼ P. (Ft )t≥0 . However.3). we started by specifying the Pdynamics of the short rates. All contingent claims can be priced by taking Qexpectations of their discounted payoffs. The market price of risk (and hence the objective measure P) can be inferred by statistical methods from historical observations of price movements.2. Ft )-Brownian motion.3. and b and σ continuous functions on R+ × Z. r(t)) dW (t) (7. the savings account alone cannot be used to replicate bond payoffs: the model is incomplete. It is custom (and we follow this tradition) to postulate the Q-dynamics (Q being the EMM) of r which implies the Q-dynamics of all bond prices by (7. this is also reflected by the non-uniqueness of the EMM (the market price of risk). we are unable to identify the market price of risk. We let W denote a d-dimensional (Q. A short rate model is not fully determined without the exogenous specification of the market price of risk. r(u)) dW (u) and such that exp − t T r(u) du ∈ L1 (Q) (7. In other words.2. We assume that for any ρ ∈ Z the stochastic differential equation (SDE) dr(t) = b(t.

If in addition either 1. r) + b(t.2 ([0. Sufficient for the existence and uniqueness is Lipschitz continuity of b(t. and assume that F = F (t. It turns out that P (t. r) and σ(t. r) in r. r) + a(t. This is a general property of certain functionals of Markov process.80 CHAPTER 7. M is uniformly bounded. t and T . uniformly in t. or 2. r)∂r F (t. uniformly in t. then M is a true martingale.5) is always satisfied if Z ⊂ R+ . T ) = EQ exp − t r(u) du | Ft . T ]×Z) is a solution to the boundary value problem on [0. Let T > 0 and Φ be a continuous function on Z. ∂r F (t. usually referred to as Feynman–Kac formula. T ]. is enough. T ) can be written as a function of r(t). r)∂r F (t. r) := for the diffusion term of r(t).7) . r) ∈ C 1. t ≤ T. Lemma 7.1. If d = 1 then H¨lder continuity of order 1/2 o of σ in r. r) − rF (t. In the following we write a(t. σ(t. and T F (t. T ] × Z 2 ∂t F (t. is a local martingale.6) Then M (t) = F (t. A good reference for SDEs is the book of Karatzas and Shreve [14] on Brownian motion and stochastic calculus. Notice that (7. r(t)) ∈ L2 [0.2. (7.5) allows us to define the T -bond prices T P (t. r) 2 2 (7. r(t))e− t 0 r(u) du σ(t. Condition (7. r(t)) = EQ exp − t r(u) du Φ(r(T )) | Ft . T ]. r) = Φ(r). r) = 0 F (T. SHORT RATE MODELS for all 0 ≤ t ≤ T . t ∈ [0. r(t))e− t 0 r(u) du .

Multiplying with e t 0 r(u) du We call (7. One can also show the converse that the expectation on the right hand side of (7. r(t)) dW (t) r(u) du σ(t. 0 r(u) du Φ(r(T )) | Ft .7)) equals F (t.2. r(t)). T ] × Z). r(t)) − r(t)F (t. we have found a pricing algorithm. r(t)) 2 + a(t. r(t))e− t 0 t 0 r(u) du σ(t.2. DIFFUSION SHORT RATE MODELS Proof. In any case. r(t) (and T ) P (t. We can apply Itˆ’s formula to M and obtain o dM (t) = ∂t F (t. r(t). Hence M is a local martingale. PDEs in less than three space dimensions are numerically feasible. and the dimension of Z is one. The nuisance is that we have to solve a . It is now clear that either Condition 1 or 2 imply that M is a true martingale. we have only shown that if a smooth solution F of (7.7) conditional on r(t) = r can be written as F (t. Since T M (T ) = Φ(r(T ))e− 0 r(u) du we get F (t. In particular.2 ([0.6) the term structure equation for Φ.6) exists and satisfies some additional properties (Condition 1 or 2) then the time t price of the claim Φ(r(T )) (which is the right hand side of (7. T ) = F (t. Is it computationally efficient? Solving PDEs numerically in more than three dimensions causes difficulties. r(t)) dW (t). for Φ ≡ 1 we get the T -bond price P (t. r(t)) e− t 0 81 r(u) du dt + ∂r F (t. r(t))∂r F (t. Its solution F gives the price of the T -claim Φ(r(T )). r)∂r F (t.6) but usually only in a weak sense. r) where F solves the term structure equation (7.7. r(t))e− = ∂r F (t. T ). r(t)) + b(t. Strictly speaking. r(t))e − t 0 T r(u) du = M (t) = EQ exp − yields the claim. This is general Markov theory and we will not prove this here.2. T ) as a function of t. Remark 7. which in particular means that F may not be in C 1.

dr(t) = β(t)r(t) dt + σ(t)r(t) dW (t). 8. Hence short rate models that admit closed form solutions to the term structure equation (7. 6. dr(t) = (b + βr(t)) dt + σ 3.2. 1990): Z = R+ . d (t) = (b(t) + β(t) (t)) dt + σ(t) dW (t). Cox–Ingersoll–Ross (CIR. Vasicek (1977): Z = R.82 CHAPTER 7. Black–Karasinski (1991): Z = R+ . 4. SHORT RATE MODELS PDE for every single zero-coupon bond price function F (·. the parameters are real-valued. dr(t) = b(t) dt + σ dW (t). Dothan (1978): Z = R+ . b ≥ 0. 7.6). dr(t) = (b(t) + β(t)r(t)) dt + σ(t) dW (t). Black–Derman–Toy (1990): Z = R+ . dr(t) = βr(t) dt + σr(t) dW (t). 5. r(t) dW (t). dr(t) = (b(t) + β(t)r(t)) dt + σ(t) r(t) dW (t). (t) = log r(t). Hull–White (extended CIR. T ). T > 0. From that we might want to derive the yield or even forward curve. If not otherwise stated. 1990): Z = R. 1985): Z = R+ . Ho–Lee (1986): Z = R. 7. For all examples we have d = 1. are favorable. If we do not impose further structural assumptions we may run into regularity problems. at least for Φ ≡ 1. Hull–White (extended Vasicek. 2. . b(t) ≥ 0. ·. 1. dr(t) = (b + βr(t)) dt + σ dW (t).1 Examples This is a (far from complete) list of the most popular short rate models.

7. It turns out that it is often too restrictive and will provide a poor fit of the current data in terms of accuracy (least squares criterion). r. But F (0. T. σ) is just a parametrized curve family with three degrees of freedom. Say we have chosen the Vasicek model. for some smooth functions A and B.6). Usually. the initial term structure and hence the initial yield and forward curve are fully specified by the term structure equation (7. β. By letting the parameters depend on time one gains infinite degree of freedom and hence a perfect fit of any given curve. T ) = exp(−A(t. T ) = 0. T ) − B(t. T ) = B(T. r. Then the implied T -bond price is a function of the current short rate level and the three model parameters b. The nice thing about ATS models is that they can be completely characterized. T )r). β. r(0). the functions b(t) etc are fully determined by the empirical initial yield curve. 7. T ) = F (0. r(0). INVERTING THE YIELD CURVE 83 7. . The most tractable models are those where bond prices are of the form F (t.6) to match a given initial yield curve. Therefore the class of time-inhomogeneous short rate models (such as the Hull–White extensions) was introduced. b. b. Such models are said to provide an affine term structure (ATS). β and σ P (0.4 Affine Term Structures Short rate models that admit closed form expressions for the implied bond prices F (t.3. T ) Once the short rate model is chosen. T ) = F (0. T ) are favorable. T. r(0). r. Notice that F (T. one may want to invert the term structure equation (7. T ) = 1 implies A(T. Conversely. σ).3 Inverting the Yield Curve T → P (0.

The short rate model (7. ∂t B(t. Z = R: necessarily α(t) = 0 and a(t) ≥ 0. This is the (Hull–White extension of the) Vasicek model. and β is arbitrary. T ) − b(t)B(t.10) Proof. r) and b(t.9) (7. T2 ) is invertible. We insert F (t.1. α. β in (7. Hence we can find T1 > T2 > t such that the matrix B 2 (t. Black–Derman–Toy and Black–Karasinski models have an ATS. T ) = ∂t A(t. r) and b(t. SHORT RATE MODELS Proposition 7. T ) − b(t. In fact. and b. ·) and B 2 (t. t) = 0.8) can be further specified. T ) = a(t)B 2 (t. b.8) for some continuous functions a. T )r) in the term structure equation (7. r) = b(t) + β(t)r. (7. T ) − β(t)B(t. T ) − β(t)B(t. r) by (7. β are arbitrary. T1 ) −B(t. A(T. .11) for a(t.1 we see that all short rate models except the Dothan. Looking at the list in Section 7.6) and obtain a(t.8). ·) ≡ B(t. which yields (7. it can be shown that every ATS model can be transformed via affine transformation into one of the two cases 1. (7. ·) are linearly independent since otherwise B(t.11) reads a(t)B 2 (t. Z = R+ : necessarily a(t) = 0. T ) = α(t)B 2 (t.84 CHAPTER 7. T ) + 1)r.4. T1 ) B 2 (t. T ) − b(t)B(t. T ) − B(t. They have to be such that a(t. T ). r).2. r. T ) + (∂t B(t. r)B 2 (t. B(T. T ) − 1. (7.8). 2.4) provides an ATS only if its diffusion and drift terms are of the form a(t. Hence we can solve (7. T ) = 0. This is the (Hull–White extension of the) CIR model. Terms containing r must match. α(t) ≥ 0 and b(t) ≥ 0 (otherwise the process would cross zero). T ) + α(t)B 2 (t. Replace a(t. β. This proves the claim. r) ≥ 0 and r(t) does not leave the state space Z. T2 ) −B(t. T ) = 0. α. b. r) = a(t) + α(t)r and b(t. The functions A and B in turn satisfy the system ∂t A(t. The functions a. so the left hand side of (7. T ) = exp(−A(t. which trivially would lead to be above results with a(t) = α(t) ≡ 0.11) The functions B(t. r)B(t. T ) r.

T ) − bB(t. It follows that r(t) is a Gaussian process with mean E [r(t)] = r(0)eβt + and variance t b βt e −1 β σ 2 2βt e −1 . 2β V ar[r(t)] = σ e Hence 2 2βt 0 e−2βs ds = Q[r(t) < 0] > 0.4).5 Some Standard Models We discuss some of the most common short rate models. Vasicek assumed the market price of risk to be constant. BM[6](Chapter 3) 7. so that also the objective P-dynamics of r(t) is of the above form. B(T.10) become σ2 2 ∂t A(t.9)–(7. T ) = 0. 2 ∂t B(t. → B[3](Section 17. for t → ∞. T ). T ) − 1. T ) = 0.1. and r(t) converges to a Gaussian random variable with mean b/|β| and variance σ 2 /(2|β|). T ) = 1 β(T −t) e −1 β . Equations (7. SOME STANDARD MODELS 85 7. A(T.5.1 Vasicek Model dr = (b + βr) dt + σ dW The solution to is explicitly given by (→ exercise) r(t) = r(0)eβt + b βt e − 1 + σeβt β t 0 e−βs dW (s). see Figure 7. which is not satisfactory (although this probability is usually very small). The explicit solution is B(t. If β < 0 then r(t) is mean-reverting with mean reversion level b/|β|.7.5. T ) = B (t. T ) = −βB(t.

It is worth to mention that. = 4β 3 β2 We recall that zero-coupon bond prices are given in closed form by P (t.11 0. T ) ds + b B(s. T ) ds 2 t t σ 2 4eβ(T −t) − e2β(T −t) − 2β(T − t) − 3 eβ(T −t) − 1 − β(T − t) +b .86.5. T ) − B(t. SHORT RATE MODELS Figure 7.2 Cox–Ingersoll–Ross Model dr(t) = (b + βr(t)) dt + σ r(t) dW (t). for b ≥ 0. r(0) ≥ 0.0148 and r(0) = 0. T ) − =− ∂s A(s.08.1: Vasicek short rate process for β = −0. T ) = exp (−A(t.1 0. Short Rates 0. T ) ds t T σ2 T 2 B (s.09 0. T )r(t)) . T ) = A(T.08 0.6). b/|β| = 0. .09 (mean reversion level). 7.07 Time in Months 50 100 150 200 250 300 350 and A is given as ordinary integral T A(t.86 CHAPTER 7. σ = 0. It is possible to derive closed form expression also for bond options (see Section 7.12 0.

7.10) now becomes non-linear σ2 2 B (t. if b ≥ σ 2 /2 then r > 0 whenever r(0) > 0. Even more. 2 This is called a Riccati equation. this is mainly the reason why the CIR model is so popular. B(T.5. This also holds when the coefficients depend continuously on t. 7. it can be shown that also bond option prices are explicit(!) Together with the fact that it yields positive interest rates. T ) = 0. T ) − βB(t. s ≤ t. Hence also in the CIR model we have closed form expressions for the bond prices. which yields dr(t) = βr(t) dt + σr(t) dW (t) as Q-dynamics. T ) = (γ − β) (eγ(T −t) − 1) + 2γ ∂t B(t. The ATS equation (7. The market price of risk is chosen to be constant. SOME STANDARD MODELS 87 has a unique strong solution r ≥ 0. Thus the Fs -conditional distribution of r(t) is lognormal with mean and variance (→ exercise) E[r(t) | Fs ] = r(s)eβ(t−s) 2 (t−s) V ar[r(t) | Fs ] = r 2 (s)e2β(t−s) eσ −1 . It is good news that the explicit solution is known 2 eγ(T −t) − 1 B(t. as it is the case for the Hull–White extension. Integration yields 2b log σ2 2γe(γ−β)(T −t)/2 (γ − β) (eγ(T −t) − 1) + 2γ A(t. for every r(0) ≥ 0. .5. T ) = − . T ) = where γ := β 2 + 2σ 2 . T ) − 1. This is easily integrated r(t) = r(s) exp β − σ 2 /2 (t − s) + σ(W (t) − W (s)) .3 Dothan Model Dothan (78) starts from a drift-less geometric Brownian motion under the objective probability measure P dr(t) = σr(t) dW P(t). Moreover.

T ) − b(t)B(t. T ) = T − t.9)–(7. ∂t A(t. A(t. σ2 (T − t)3 + 6 T t b(s)(T − s) ds. see BM[6]). T ). T ) = 0. T ) = −1. T ) = 0.5. This means that in arbitrarily small time the bank account growths to infinity in average. The idea of lognormal rates is taken up later by Sandmann and Sondermann (1997) and many others. A major drawback of lognormal models is the explosion of the bank account.10) become σ2 2 B (t. Let ∆t be small. SHORT RATE MODELS The Dothan and all lognormal short rate models (Black–Derman–Toy and Black–Karasinski) yield positive interest rates. B(T. one shows that the price of a Eurodollar future is infinite for all lognormal models. .88 CHAPTER 7. then ∆t E[B(∆t)] = E exp r(s) ds 0 ≈ E exp r(0) + r(∆t) ∆t 2 . 7. But such an expectation is infinite. T ) = − A(T. which finally led to the so called market models with lognormal LIBOR or swap rates. We face an expectation of the type E[exp(exp(Y ))] where Y is Gaussian distributed. But no closed form expressions for bond prices or options are available (with one exception: Dothan admits an “semi-explicit” expression for the bond prices.4 Ho–Lee Model For the Ho–Lee model dr(t) = b(t) dt + σ dW (t) the ATS equations (7. 2 ∂t B(t. T ) = Hence B(t. Similarly.

t) + σ 2 t(T − t) + r(t). 2 That is. However. this flexibility has its price: the model cannot be handled analytically in general. T ) be the observed (estimated) initial forward curve. Equation (7. T ) − f ∗ (0. r(t) fluctuates along the modified initial forward curve. gives a perfect fit of f ∗ (0.5. 2 7.7. T )r(t) = − σ2 (T − t)2 + 2 T 89 b(s) ds + r(t). T ) = 0 . and we have f ∗ (0. T ) = e− T t 2 f ∗ (0. It is interesting to see that t r(t) = r(0) + 0 b(s) ds + σW (t) = f ∗ (0.5.5 Hull–White Model The Hull–White (1990) extensions of Vasicek and CIR can be fitted to the initial yield and volatility curve. B(T. t Let f ∗ (0. T ) = −βB(t.s) ds+f ∗ (0. T ) − 1. Plugging this back into the ATS yields f (t. s) + σ 2 s. t) + σ 2 t2 + σW (t).10) for B(t. T ) is just as in the Vasicek model ∂t B(t. T ). T ) + ∂T B(t. T ) = f ∗ (0. SOME STANDARD MODELS The forward curve is thus f (t. t) = E[r(t)] − σ 2 t2 . In this model we choose the constants β and σ to obtain a nice volatility structure whereas b(t) is chosen in order to match the initial yield curve.t)(T −t)− σ2 t(T −t)2 −(T −t)r(t) . T ) = ∂T A(t. We can also integrate this expression to get P (t. Then b(s) = ∂s f ∗ (0. We therefore restrict ourself to the following extension of the Vasicek model that was analyzed by Hull and White 1994 dr(t) = (b(t) + βr(t)) dt + σ dW (t).

90 with explicit solution CHAPTER 7. σ 2 β(T −t) e −1 2β 2 eβ(T −t) − eβ(T +t) φ(0) = r(0). T ) + g(T )). =:φ(T ) σ = − 2 eβT − 1 2β =:g(T ) + 0 The function φ satisfies ∂T φ(T ) = βφ(T ) + b(T ). . we do not worry about integrability conditions. 7. T )r(0) b(s)eβ(T −s) ds + eβT r(0) . T ) ds + 0 2 0 2 T b(s)∂T B(s. T ) − eβ(T −t) f ∗ (0. t) − + eβ(T −t) r(t). T ) + ∂T B(0. The discussion is informal. It follows that b(T ) = ∂T φ(T ) − βφ(T ) = ∂T (f ∗ (0.6 Option Pricing in Affine Models We show how to price bond options in the affine framework. T ) = −∂s B(s. T ) + ∂T B(0. The procedure has to be carried out rigorously from case to case. T ) ds + t t b(s)B(s. SHORT RATE MODELS B(t. T )r(0) = σ2 2 T T ∂s B 2 (s. T )) f ∗ (0. T ) = − σ2 2 T T B 2 (s. T ) + g(T )) − β(f ∗ (0. β Equation (7. T ) now reads A(t. T ) = ∂T A(0.9) for A(t. T ) = 1 β(T −t) e −1 . T ) ds We consider the initial forward curve (notice that ∂T B(s. Plugging in and performing performing some calculations eventually yields f (t. T ) = f ∗ (0.

T. by plugging the right hand side below in the term structure equation (7.T.S))r(0) .T. 0) = A(t. T.T )−B(t.S)−B(T.S))+(B(0. λ) = α(t)ψ 2 (t. r(s) ds −λr(T ) e = E e− T 0 r(s) ds −A(T. But e− 0 r(s) ds dQS = dQ P (0. Hence we have shown that the (extended) Laplace transform of r(T ) with respect to QS is EQS e−λr(T ) = eA(0. OPTION PRICING IN AFFINE MODELS Let r(t) be a diffusion short rate model with drift b(t) + β(t)r. T.S)−φ(0.S))−ψ(0.λ)−ψ(t.9)–(7. T ) and ψ(t.λ+B(T. T. T.λ+B(T. T ). Since discounted zero-coupon bond prices are martingales we obtain for T ≤ S (→ exercise) E e− S 0 T t r(s) ds −λr(T ) e | Ft = e−φ(t. λ) − 1 ψ(T.S))r(T ) e = e−A(T. T. and indeed. λ) = 0 ∂t ψ(t. T. T ) = e−A(t.λ+B(T. Let λ ∈ C. λ) − b(t)ψ(t.S)−A(T. one sees that E e− In fact. Now let t = 0 (for simplicity only).T.7. T.S)−ψ(0.T.10).S) E e− T 0 r(s) ds −(λ+B(T. T. λ) = λ. λ) = a(t)ψ 2 (t. λ) φ(T. λ) − β(t)ψ(t.λ)r(t) . 91 This looks much like the ATS equations (7.6. T. diffusion term a(t) + α(t)r and ATS P (t. .S)))r(0) . 0) = B(t. S) S defines an equivalent probability measure QS ∼ Q on FS .S)−φ(0. the so called Sforward measure.λ+B(T.T. T.S)r(T ) −λr(T ) e e = e−A(T.T )r(t) .6). we have φ(t. and φ and ψ be given as solutions to ∂t φ(t.

1{r(T )≤r∗ } − KE e− r(s) ds 1{r(T )≤r∗ } 7. A similar closed form expression is available for the price of a put option. α = 0). S) + log K .g.g.S)r(T ) − K + . For β = −0. S. T )Φ 1 (T. The pricing of the option boils down to the computation of the probability of the event {r(T ) ≤ r ∗ } under the S. S)Φ where 1 (T.92 CHAPTER 7. r∗ − r∗ − We obtain (→ exercise) π = P (0.09 .6.S)−B(T. this is done numerically. In general.S)−B(T. Vasicek or CIR) this distribution is explicitly known (e. b. T. r) 1 (T. In some cases (e. B(T.and T -forward measure. β const. r(0)) 2 (T ) 1 β eβT (b + βr) − b − a 2 − eβ(S−T ) − 2eβT + eβ(S+T ) β2 a 2βT e −1 2 (T ) := β := and Φ(x) is the cumulative standard Gaussian distribution function. and hence an explicit price formula for caps.S)r(T ) − K where r ∗ = r ∗ (T.S)r(T ) 1{r(T )≤r∗ } − K1{r(T )≤r∗ } A(T.S)−B(T. S) T 0 r(s) ds = P (0. one gets the distribution of r(T ) under QS . b/|β| = 0. SHORT RATE MODELS By Laplace (or Fourier) inversion.86. S)QS [r(T ) ≤ r ∗ ] − KP (0. S. T )QT [r(T ) ≤ r ∗ ]. The payoff can be decomposed according to e−A(T. We now consider a European call option on a S-bond with expiry date T < S and strike price K.1 Example: Vasicek Model (a. r(0)) 2 (T ) − KP (0. K) := − Hence π = E e− S 0 + = e−A(T. Its price today (t = 0) is π = E e− T 0 r(s) ds e−A(T. S. Gaussian or chi-square).

0525296 0. OPTION PRICING IN AFFINE MODELS 93 (mean reversion level).00215686 0. as in Figure 7.0326962 0.0402203 Figure 7. one gets the ATM cap prices and Black volatilities shown in Table 7.017613 0.0443967 0.0221081 0. Maturity 1 2 3 4 5 6 7 8 10 12 15 20 30 ATM prices 0.0370565 0.2: Vasicek ATM cap Black volatilities.0148 and r(0) = 0.2 (→ exercise).028963 0.1.6.0815358 0. Table 7.01503 0.106348 0.0199647 0.0613624 0.08.0121906 0.025847 0.0485755 0.14 0.129734 0. In contrast to Figure 2. σ = 0.0562337 0. the Vasicek model cannot produce humped volatility curves.00567477 0.1 0. 0.12 0.1 and Figure 7.06 0.04 5 10 15 20 25 30 .0647515 0.08 0.1: Vasicek ATM cap prices and Black volatilities.7.0915455 0.0743607 0.0689651 0.1.00907115 0.0416089 ATM vols 0.

94 CHAPTER 7. SHORT RATE MODELS .

Chapter 8 Heath–Jarrow–Morton (HJM) Methodology → original article by Heath. 95 . 1992) [9]. Jarrow and Morton (HJM.

HJM METHODOLOGY .96 CHAPTER 8.

T )B(t) This probability measure has already been introduced in Section 7. B(t) are strictly positive martingales.1 T -Bond as Numeraire 1 1 > 0 and EQ =1 P (0. T )B(T ) P (0.6. T ) . 9. t ∈ [0. T )B(T ) Fix T > 0.Chapter 9 Forward Measures We consider the HJM setup (Chapter 8) and directly focus on the (unique) EMM Q ∼ P under which all discounted bond price processes P (t. Since we can define an equivalent probability measure QT ∼ Q on FT by dQT 1 = . T ]. It is called the T -forward measure. 97 . T ) dQT |F t = E Q | Ft = . dQ P (0. dQ dQ P (0. T )B(T ) For t ≤ T we have dQT P (t.

since • we only have to compute the single integral EQ [X | Ft ]. FORWARD MEASURES t ∈ [0.1) B(T ) Its fair price at time t ≤ T is then given by π(t) = EQ e− T t r(s) ds X | Ft . let X be a T -claim such that X ∈ L1 (Q. Since Q is related to the risk-free asset.T ) P (0. one usually calls Q the risk neutral measure. P (s. T ) We thus have an entire collection of EMMs now! Each QT corresponds to a different numeraire.T ) P (t. and integrate with respect to that distribution. T )EQ [X | Ft ] . Let s ≤ t ≤ S ∧ T . CHAPTER 9. S) . (9. S) | Fs = P (t.T ) P (s.T ) B(s) = P (s. P (t. S ∧ T ]. .S) B(s) P (s.98 Lemma 9. if r is deterministic) we would have π(t) = P (t.T )B(t) P (t. Bayes’ rule gives EQ T EQ P (t.1. T -forward measures give simpler pricing formulas.S) P (0. P (t. namely the T -bond. For any S > 0. FT ). Indeed. for instance. S) .T )B(s) | Fs P (s. If B(T )/B(t) and X were independent under Q (which is not realistic! it holds. a much nicer formula.1. T ) is a QT -martingale. T To compute π(t) we have to know the joint distribution of exp − t r(s) ds and X. which in most cases turns out to be rather hard work. Thus we have to compute a double integral. Proof. T ) = P (t.

Let X be a T -claim such that (9. T )EQT [X | Ft ] . T ) · σ(s. 9. And π(t) = P (0. The forward rates then follow the dynamics t T t f (t. (9. Proof. T ) can be observed at time t and does not have to be computed. T )B(T ) (9. T )B(t) P (0.2.2).1)). the expression of the forward rates f (t.2 An Expectation Hypothesis Under the forward measure the expectation hypothesis holds.3). T ) EQT [X | Ft ] = P (0.1. AN EXPECTATION HYPOTHESIS 99 • the bond price P (t.4) . The good news is that the above formula holds — not under Q though. T )B(T ) P (t. P (0. u) du ds + s 0 σ(s. T ) dW (s). Bayes’s rule yields EQT [|X|] = EQ whence (9. That is. T ) + 0 σ(s.3) (9. T ) as conditional expectation of the future short rate r(T ). T )EQT [X | Ft ] . Then EQT [|X|] < ∞ and π(t) = P (t.9. |X| < ∞ (by (9. but under QT : Proposition 9.2) which proves (9.2. we write W for the driving Q-Brownian motion. T )B(t) = P (t.1) holds. T ) = f (0. To see that. T )B(t)EQ X | Ft P (0.

5) This equation has a unique solution P (t. T ) dW T (s). Under the above assumptions.2. T ) = P (0. (9. T ) = EQT [r(T ) | Ft ] .6) W T (t) = W (t) + 0 s σ(s. T )Et B(t) We thus have dQT |F = E t dQ t Girsanov’s theorem applies and t T T T − · σ(·. Hence. − · σ(·. t ∈ [0. Equation (9.100 CHAPTER 9. if T EQ T then σ(s. u) du dW (s). T ) + 0 σ(s. T ))t∈[0. s (9. u) du ds. T ) = P (0. T ) 0 2 ds < ∞ (f (t. T ) + B(t) t 0 P (s. T ) = f (0. T ) − B(s) T σ(s. . u) du · W . is a QT -Brownian motion. Lemma 9. u) du · W .4) now reads t f (t. the expectation hypothesis holds under the forward measures f (t.T ] Summarizing we have thus proved is a QT -martingale. T ].1. FORWARD MEASURES The Q-dynamics of the discounted bond price process is P (t.

S) ≥ K) = P (0. T ) exp 0 v(s. S) σT. We already know that dP (t.T ] t σ(t.8) . S) ≥ K) − KEQ B(T )−1 1(P (T.7) is a is a QS -martingale and QT -martingale. T ) 2 2 ds where v(t. P (t. This option pricing formula holds in general.S) P (t. S) 1(P (T. S) = σ(s. T ) = r(t) dt + v(t.T ] × exp = where 0 1 σT. u) du. In fact (→ exercise) P (t. T ) − v(s.S) t∈[0. S) ≥ K] . We proceed as in Section 7. T ) := − We also know that P (t.S (s) dW (s) − 2 t 0 t v(s. T (9. S) P (0.S (s) := v(s. T ) 0 2 − v(s. S) 2 2 ds P (0.S (s) dW S (s) − 1 2 S t σT. S) ≥ K] − KP (0. T )QT [P (T. OPTION PRICING IN GAUSSIAN HJM MODELS 101 9. T ) exp P (0. S)QS [P (T. S) − K)+ .T ) (9.3. T ) dW (t) P (t. T ) = P (0. S) t t∈[0.6 and decompose π = EQ B(T )−1 P (T.9.T ) P (t. T ) P (0. T ) dW (s) + 0 T r(s) − 1 v(s.S (s) 0 ds σT. u) du. T ) = P (t. Its price at time t = 0 (for simplicity only) is π = E Q e− T 0 r(s) ds (P (T. T ) and hence t t P (t.3 Option Pricing in Gaussian HJM Models We consider a European call option on an S-bond with expiry date T < S and strike price K.

S) P (0. .S (s) ds σT. FORWARD MEASURES × exp − = 0 1 σT.S (s) ds .S) T 0 1 2 T 0 2 σT.2 = P (0.S (s) 2 ds σT. T ) are Gaussian distributed.T ) and P (T.S (s) 2 2 ds . T ) σT.S (s) dW (s) − 2 t 0 t v(s. T ) ≤ P (T. . T ) This suggests to look at those models for which σT. . We thus assume that σ(t.3. T ) = (σ1 (t. T ).8) and Φ is the standard Gaussian CDF. σd (t.S (s) dW T (s) − 1 2 t σT. S) ≥K . log d1. T ) t CHAPTER 9. Proposition 9. S) P (t. S) ≥ K] = QS QT [P (T.1.T ) − log P (0. S) 0 2 − v(s. S) K P (T. Proof. σT. the option price is π = P (0. T )) are deterministic functions of t and T .102 and P (0.T ) T 0 where ± 1 2 T 0 σT. .T ) are log-normally distributed under the respective P (T. Now observe that QS [P (T.S is deterministic.S (s) is given in (9.S) KP (0. S)Φ[d1 ] − KP (0. S) = P (t. and P (T.S (s) 0 ds . T )Φ[d2 ]. S) exp − P (0. It is enough to observe that log P (T. T ) P (0. and hence forward rates f (t.T ) + P (T. We obtain the following closed form option price formula. P (T. Under the above Gaussian assumption.S) forward measures. T ) 2 2 ds P (0. S) ≥ K] = QT 1 P (T.S) hence P (T.

9.3. Of course.S (s) 2 ds σT.S (s) ds are standard Gaussian distributed under QS and QT .S) P (T.3.T ) + T 0 1 2 σT.1 can now be obtained as a corollary of Proposition 9. OPTION PRICING IN GAUSSIAN HJM MODELS and T 0 2 103 P (0.T ) − log P (0. the Vasicek option price formula from Section 7. . respectively.6.1 (→ exercise).S) log P (T.

FORWARD MEASURES .104 CHAPTER 9.

T ) = EQT [Y | Ft ] . T. etc. which are actively traded on many exchanges. any traded or non-traded asset. a commodity such as copper. 105 T t T t r(s) ds (Y − f (t. the holder of the contract (long position) pays f (t.1 Forward Contracts A forward contract on Y. T. and futures. The underlying is in both cases a T -claim Y. Y) and receives Y from the underwriter (short position). for some fixed future date T .Chapter 10 Forwards and Futures → B[3](Chapter 20). and with the forward price f (t. • at t. contracted at t. with time of delivery T > t. an interest rate. This can be an exchange rate. T. or Hull (2002) [10] We discuss two common types of term contracts: forwards. Y)) | Ft = 0. which are mainly traded OTC. Y) is defined by the following payment scheme: • at T . the forward price is chosen such that the present value of the forward contract is zero. an index. thus EQ e − This is equivalent to f (t. r(s) ds Y | Ft . Y) = 1 EQ e − P (t. T. 10.

T. T. Y)) | Fs = E Q e− T s r(u) du Y | Fs − P (t. etc. or a commodity such as copper. Y) − F (s. So there is a continuous cash-flow between the two parties of a futures contract. The volumes in which futures are traded are huge. which is EQ e − T s r(u) du (Y − f (t. if entered at t. t] the holder of the contract receives (or pays. which makes the futures contract on Y. T. an S-bond delivered at T ≤ S is P (t. FORWARDS AND FUTURES Examples The forward price at t of 1.S) . the holder of the contract (long position) pays F (T .T ) S(t) . . any traded asset S delivered at T is The forward price f (s. T )f (t. 10. T. equal to zero. and selling short makes it possible to hedge against the underlying. Y). if negative) the amount F (t. T. Y). Y) has to be distinguished from the (spot) price at time s of the forward contract entered at time t ≤ s.T ) 3. They are required to keep a certain amount of money as a safety margin. T. there is a market quoted futures price F (t.2 Futures Contracts A futures contract on Y with time of delivery T is defined as follows: • at every t ≤ T . 2. This might be an index which includes many different (illiquid) instruments.106 CHAPTER 10. • at T . • during any time interval (s. Holding a (short position in a) futures does not force you to physically deliver the underlying object (if you exit the contract before delivery date). Y) and receives Y from the underwriter (short position). P (t. T. P (t. Y) (this is called marking to market). a dollar delivered at T is 1. One of the reasons for this is that in many markets it is difficult to trade (hedge) directly in the underlying object. gas or electricity.

This has to hold for any partition (ti ).1) based on the above characterization of a futures contract. Indeed. B(s) t . Y) = EQ [Y | Ft ] . B(ti ) But the futures contract has present value zero.F B T = s t 1 dF (s). i = 1. We face a continuum of cashflows in the interval (t.2. B(s) since the quadratic variation of 1/B (finite variation) and F (continuous) is zero. . First.1) Often. hence EQ [Σ | Ft ] = 0. If we let the partition become finer and finer this expression converges in probability towards T t 1 dF (s) + B(s) T d t 1 . We now give a heuristic argument for (10. FUTURES CONTRACTS 107 Suppose Y ∈ L1 (Q). The present value of the corresponding cashflows F (ti ) − F (ti−1 ) at ti . this is just how futures prices are defined . . and we may assume that o F (t) = F (t. (10. T. Now suppose we enter the futures contract at time t < T . Y) is a continuous semimartingale (or Itˆ process). . T. T ]. We can rewrite Σ as N i=1 1 (F (ti ) − F (ti−1 )) + B(ti−1 ) N i=1 1 1 − B(ti ) B(ti−1 ) (F (ti ) − F (ti−1 )) . our model economy is driven by Brownian motion and changes in a continuous way. Then the futures price process is given by the Q-martingale F (t. Under the appropriate integrability assumptions (uniform integrability) we conclude that T 1 EQ dF (s) | Ft = 0. . N . Hence there is no reason to believe that futures prices evolve discontinuously. let t = t0 < · · · < tN = t be a partition of [t. T ]. is given by EQ [Σ | Ft ] where N Σ := i=1 1 (F (ti ) − F (ti−1 )) .10.

T + 1/4]. T ) is the corresponding futures rate (compare with the example in Section 4. L(T )) = 1 − LF (t.4) Interest rate futures contracts may be divided into futures on short term instruments and futures on coupon bonds. and is designed to protect its owner from fluctuations in the 3-months (=1/4 years) LIBOR. T ) [Mio. Eurodollars are deposits of US dollars in institutions outside of the US. dollars]. T.1). June. 10. T ]. LF (t. T ) [100 per cent] where LF (t. As t tends to T . The futures price.2). 4 .108 and that t CHAPTER 10.3 Interest Rate Futures → Z[27](Section 5. which implies (10. used for the marking to market. September and December. is a Q-martingale. moreover T EQ then 0 1 d M. FORWARDS AND FUTURES M (t) = 0 1 dF (s) = EQ B(s) T 0 1 dF (s) | Ft . Fix a maturity date T and let L(T ) denote the 3-months LIBOR for the period [T. B(s) t ∈ [0. LIBOR is the interbank rate of interest for Eurodollar loans. The Eurodollar futures contract is tied to the LIBOR. F T] <∞ F (t) = 0 1 dM (s). The maturity (delivery) months are March. B(s) t ∈ [0. is a Q-martingale. T ) tends to L(T ). The market quote of the Eurodollar futures contract on L(T ) at time t ≤ T is 1 − LF (t. We only consider an example from the first group. M B(s)2 t s = EQ [ F. If. prevailing at T . T ].2. is defined by 1 F (t. It was introduced by the International Money Market (IMM) of the Chicago Mercantile Exchange (CME) in 1981.

T ) F (t. FUTURES IN A GAUSSIAN SETUP 109 Consequently. 4 We also see that the final price F (T . T ) = F (t.1. T + 1/4) as one might suppose. Instead. L(T )) | Ft ] = 1 − EQ [L(T ) | Ft ] . Hence the Q-dynamics of S is of the form dS(t) = r(t) dt + ρ(t) dW (t). Futures in a Gaussian Setup Let S be the price process of a traded asset.10. T. the 4 underlying Y is a synthetic value. P (t. where T v(t. L(T )) = 1 − 1 L(T ) = Y is not 4 P (T. T ) are deterministic functions in t. L(T )) 4 1 = EQ [F (T .4 Forward vs. Suppose ρ(t) and v(t. S(t) for some volatility process ρ.01%) in the futures rate LF (t. a change of 1 basis point (0.4.4. On the other hand. 4 we obtain an explicit formula for the futures rate LF (t. T ) = EQ [L(T ) | Ft ] . settlement is made in cash. S(T )) = EQ [S(T ) | Ft ]. T. 10. S(T )) = S(t) . Proposition 10. Fix a delivery date T . T + 1/4) = 1 − 1 L(T )P (T. The forward and futures prices of S for delivery at T are f (t. since 1 1 − LF (t. T ) leads to a cashflow of 106 × 10−4 × 1 = 25 [dollars]. T ) = − σ(t. T. T. In fact. FORWARD VS. T. u) du t . At maturity there is no physical delivery. Under Gaussian assumption we can establish the relationship between the two prices.

T. as desired. T ) ds . S(T )) = EQ [f (T . T ) is negative d S. S(T )) | Ft ] T = f (t. S(T )) = f (t. T ) ≤ 0 then the futures price dominates the forward price. if the instantaneous correlation of dS(t) and dP (t. Then T F (t. T ) ds . T f (T . Proof. T.7)). S(T )) exp − T t 1 µ(s) dW (s) − 2 T µ(s) t 2 ds × exp t µ(s) · v(s. T. S(T )) exp t µ(s) · v(s. S(T )) = S(0) exp − P (0. T. FORWARDS AND FUTURES is the volatility of the T -bond (see (9. T. Hence. S(T )) = f (t. Write µ(s) := v(s. By assumption µ(s) is deterministic. T ) ds . T ) − ρ(s). T. T ) ds for t ≤ T . T )ρ(t) · v(t. T EQ exp − and t µ(s) dW (s) − 1 2 T µ(s) t 2 ds | Ft = 1 F (t. T. T. It is clear that f (t. . T ) dt t = S(t)P (t. T ) − ρ(s)) · v(s.110 CHAPTER 10. P (·. S(T )) exp t (v(s. T ) t t 0 µ(s) dW (s) − 1 2 t µ(s) 0 2 ds × exp and hence 0 µ(s) · v(s. Consequently.

4. FORWARD VS. u) ≥ 0 for all s ≤ min(u. T ) = EQ [r(T ) | Ft ] − t σ(s. Hence.2. T ) et( − (S − T )P (t. S) for t ≤ T < S. T ) · S T σ(s. FUTURES IN A GAUSSIAN SETUP Similarly. if σ(s. In a Gaussian HJM framework (σ(t. v) · σ(s. .10. S) = EQ [F (T.4. S) | Ft ] T P (t. v) then futures rates are always greater than the corresponding forward rates. one can show (→ exercise) 111 Lemma 10.v) dv· S s σ(s. s F (t.u) du)ds −1 σ(s. T. T ) deterministic) we have the following relations (convexity adjustments) between instantaneous and simple futures and forward rates T T f (t. u) du ds.

112 CHAPTER 10. FORWARDS AND FUTURES .

S) d P (·. u)du σ(t. • analytically: the family of attainable forward curves H = {H(·. we now allow for multiple factors. r) | r ∈ R} is only one-dimensional. P (·. P (·. is one-dimensional. T ) = H(T − t. S) = T t T t σ(t.Chapter 11 Multi-Factor Models We have seen that every time-homogeneous diffusion short rate model r(t) induces forward rates of the form f (t. since the driving (Markovian) factor. u)du = 1. T ). u)du σ(t. u)du σ(t. r(t)). Z(t)) 113 . This a one-factor model. To gain more flexibility. r(t). Fix m ≥ 1 and a closed set Z ⊂ Rm (state space). T ) t t t S t S t d P (·. for some deterministic function H. The infinitesimal increments of all bond prices are perfectly correlated d P (·. This is too restrictive from two points of view: • statistically: the evolution of the entire yield curve is explained by a single variable. A (m-)factor model is an interest rate model of the form f (t. T ) = H(T − t. S). T ). P (·.

z) := exp − H(s.2 (R+ × Z). dZ(t) = b(Z(t)) dt + ρ(Z(t)) dW (t) Z(0) = z0 . .T ] is a Q-local martingale. F . 0 Notice that the short rates are now given by r(t) = H(0. Z z0 (t)) e t 0 H(0. . Q). b1 ≡ 1 and ρ1j ≡ 0 for j = 1.114 CHAPTER 11. for every z0 ∈ Z.Z z0 (s)) ds t∈[0. for all z0 ∈ Z. Hence the assumption (A4) is equivalent to (A4’) Π(T − t. Z(t)). . for all z0 ∈ Z. where x Π(x. (A2) b : Z → Rm and ρ : Z → Rm×d are continuous functions. MULTI-FACTOR MODELS where H is a deterministic function and Z (state process) is a Z-valued diffusion process. We assume that (A1) H ∈ C 1. (A4) Q is the risk neutral local martingale measure for the induced bond prices P (t. . satisfying the usual conditions. (Ft ). T ) = Π(T − t. Simply set Z1 (t) = t (that is. Z z0 (t)). . Time-inhomogeneous models are included in the above setup. z) ds . Here W is a d-dimensional Brownian motion defined on a filtered probability space (Ω. d). (A3) the above SDE has a unique Z-valued solution Z = Z z0 .

Z(t))ρij (Z(t)) dWj (t). . for all t ≤ T and initial points z0 = Z(0). . z) → H(x. Z(t)) + m 1 aij (Z(t))∂zi ∂zj H(T − t. Z(t)) du. .l=1 m ρkj (Z(t))ρlj (Z(t))∂zi H(T − t.1. Z(t)) + m i=1 bi (Z(t))∂zi H(T − t. Z(t)) ∂zi H(u − t. j = 1.j=1 T = j=1 k.s. Z(t))ρij (Z(t)).1) σj (t. z) is in C 1. where a(z) := ρ(z)ρT (z). T ) = i=1 ∂zi H(T − t. Z(t)) T t t ∂zi H(u − t. . Z(t)) + d m 1 aij (Z(t))∂zi ∂zj H(T − t. d.l=1 akl (Z(t))∂zi H(T − t. Letting t → 0 we thus get the following result.11.1 No-Arbitrage Condition Since the function (x. Z(t)) dt 2 i. Z(t)) 2 i. . Z(t)) + m i=1 bi (Z(t))∂zi H(T − t.2 (R+ × Z) we can apply Itˆ’s o formula and obtain m df (t. This has to hold a. Z(t)) du = k. Hence the induced forward rate model is of the HJM type with m (11. The HJM drift condition now reads m − ∂x H(T − t. T ) = − ∂x H(T − t.j=1 d + i=1 j=1 ∂zi H(T − t. NO-ARBITRAGE CONDITION 115 11.

1). the number of unknown functions bk and akl = alk . 0 . Or. Proof. Proposition 11. one takes b and ρ (and hence a) as given and looks for a solution H for the PDE (11.1.2) can be written as m x aij (z)∂zi H(x. It turns out that the latter approach is quite restrictive on possible choices of b and a. z) and 1 ∂z ∂z H(·. z) − ∂zi H(x.j=1 ∂zi H(u. Notice that. z) du 0 0 ∂zj H(u. z) and 1 ∂z ∂z H(xk . z). Set M = m + m(m + 1)/2. there is equivalence between (A4) and m ∂x H(x. z) 2 i j x ∂zi H(u. z) du m x x 1 = ∂x aij (z) 2 i. z) − ∂zi H(·.j=1 aij (z) 1 ∂z ∂z H(x. z) − ∂zi H(·. where a is defined in (11. Remark 11.2). one takes H as given (an estimation method for the yield curve) and tries to find b and a such that (11. z) du.2.1. z) i. First. z) ∈ R+ × Z.j=1 0 ∂zi H(u. z) du .2). Under the above assumptions (A1)–(A3). This is an inverse problem.116 CHAPTER 11.2) for all (x.1 (Consistency Condition). There are two ways to approach equation (11.1. z) du 0 (11. Then there exists a sequence 0 ≤ x1 < · · · < xM such that the M × M -matrix with k-th row vector built by ∂zi H(xk . MULTI-FACTOR MODELS Proposition 11. Let z ∈ D.2) is satisfied for all (x. z) 2 i j xk ∂zi H(u. for 1 ≤ i ≤ j ≤ m.3. z) du. by symmetry. z) 2 i j · 0 ∂zi H(u. the last expression in (11. Then b and a are uniquely determined by H. are linearly independent for all z in some dense subset D ⊂ Z. z) = i=1 bi (z)∂zi H(x. Suppose that the functions ∂zi H(·. z) m + i.

Thus. any Q-diffusion model Z for z is fully determined by H. AFFINE TERM STRUCTURES 117 for 1 ≤ i ≤ j ≤ m. b(z) and a(z) are uniquely determined by (11. since the observations of z are made under the objective measure P ∼ Q.2) reduces to m m ∂x g0 (x) + i=1 zi ∂x gi (x) = i=1 1 bi (z)gi (x) − ∂x 2 x m aij (z)Gi (x)Gj (x) .4. under the stated assumption. 11. 2 i.11.1. for the market price of risk). where dQ/dP is left unspecified by our consistency considerations. z) | z ∈ Z} is used for daily estimation of the forward curve in terms of the state variable z. is invertible.j=1 (11. of Z is not affected by any Girsanov transformation. We first look at the simplest.3) where Gi (x) := 0 gi (u) du.4) m . Remark 11.2. Then the above proposition tells us that. If Ft = FtW is the Brownian filtration. Suppose that the the parametrized curve family H = {H(·.2 Affine Term Structures H(x. Consequently. then the diffusion coefficient. z) = g0 (x) + g1 (x)z1 + · · · gm (x)zm . This holds for each z ∈ D.2). namely the affine case: Here the second order z-derivatives vanish.j=1 (11. and (11. i. By continuity of b and a hence for all z ∈ Z. statistical calibration is only possible for the drift of the model (or equivalently. a(z). Integrating (11.3) yields m m g0 (x)−g0 (0)+ i=1 zi (gi (x)−gi (0)) = i=1 bi (z)Gi (x)− 1 aij (z)Gi (x)Gj (x).

(11. z) = |i|=0 gi (x) (Zt )i .6) ∂x Gk (x) = gk (0) + i=1 with initial conditions G0 (0) = · · · = Gm (0) = 0. gm (0). . . . which are related to the short rates by r(t) = f (t. t) = g0 (0) + g1 (0)Z1 (t) + · · · + gm (0)Zm (t).j=1 m m (11.4) and matching constant terms and terms containing zk s we obtain a system of Riccati equations m ∂x G0 (x) = g0 (0) + i=1 m 1 aij Gi (x)Gj (x) bi Gi (x) − 2 i.118 Now if CHAPTER 11. . .j=1 1 βki Gi (x) − αk. Notice that we have the freedom to choose g0 (0). 11. . .7) . 2 i.4) for b and a. Plugging this back into (11. G1 G1 . whence Z1 (t) is the (non-Markovian) short rate process. we can invert and solve the linear equation (11. k=1 aij (z) = aij + for some constant vectors and matrices b. . This extends what we have found in Section 7. . Since the left hand side is affine is z. β. MULTI-FACTOR MODELS G1 . .ij zk .4 for the one-factor case.ij Gi (x)Gj (x). a and αk . we obtain that also b and a are affine m bi (z) = bi + j=1 m βij zj αk. . . Gm .3 Polynomial Term Structures n We extend the ATS setup and consider polynomial term structures (PTS) H(x. Gm Gm are linearly independent functions. A typical choice is g1 (0) = 1 and all the other gi (0) = 0. G1 G2 .5) (11.

For n = 2 we have a quadratic term structure (QTS). . . Theorem 11. we denote the integral of gi by x where N := |I| = 1. Moreover.1 (Maximal Degree Problem I).2). . . . . . im ). 1 ≤ µ ≤ ν ≤ N . m} we write (µ)k for the multiindex with µ at the k-th position and zeros elsewhere.3.10) . . Do we gain something by looking at n = 3 and higher degree PTS models? The answer is no. . Proof. .11. . which has also been studied in the literature. Then necessarily n ∈ {1.8) (11. . . Define the functions 1 ∂2zi ∂z i akl (z) + Bi (z) := bk (z) ∂zk 2 k. .3. im ) | |i| ≤ n}. iN be a numbering of the set of multi-indices n I = {i = (i1 . Let i1 . . and deg a(z) = 0 if n = 2 (QTS) and deg a(z) ≤ 1 if n = 1 (ATS). Suppose that Giµ and Giµ Giν are linearly independent functions. we now shall show the amazing result that n > 2 is not consistent with (11.2) can be rewritten N N N m m (11. n} and k ∈ {1. As above. i2 . Thus for n = 1 we are back to the ATS case. 2}. 2 k. POLYNOMIAL TERM STRUCTURES 119 where we use the multi-index notation i = (i1 . µ. there exists an index i with |i| = n and gi = 0. .ν=1 (11.l=1 ∂zk ∂zl 1 ∂z i ∂z j akl (z) Aij (z) = Aji (z) := . |i| = i1 + · · · + im and i im z i = z11 · · · zm .l=1 ∂zk ∂zl Equation (11.9) µ=1 giµ (x) − giµ (0) z iµ = µ=1 Giµ (x)Biµ (z) − Giµ (x)Giν (x)Aiµ iν (z). . For µ ∈ {1. . that is. and that ρ ≡ 0. . b(z) and a(z) are polynomials in z with deg b(z) ≤ 1 in any case (QTS and ATS). In fact. Here n denotes the degree of the PTS. |i|=0 Gi (x) := 0 gi (u) du. .

. 2A(1)k (1)l (z) = akl (z).12) cannot be a polynomial in z of order less than or equal n unless n ≤ 2. This proves the first part of the theorem.11) hence b(z) and a(z) are polynomials in z with deg b(z). .12) yields deg k akk (z) = 0. In particular. . Now let n = 2. k. k ∈ {1. where degµ denotes the degree of dependence on the single component zµ . Consider 2 2A(1)k +(1)l . From the preceding arguments it is now clear that also deg l akk (z) = 0. m}. .1 if from now on we make the following standing assumptions: Z ⊂ Rm is a cone. for some constant C ∈ R+ . . But then the right hand side of (11.(1)k +(1)l (z) = akk (z)zl2 + 2akl (z)zk zl + all (z)zk .13) k. l ∈ {1. m}. . and hence deg a(z) = 0. Equation (11. . . deg a(z) ≤ n. l ∈ {1. An easy calculation shows that 2n−2 2A(n)k (n)k (z) = akk (z)n2 zk . l ∈ {1. ∀z ∈ Z. Notice that by definition degµ akl (z) ≤ (degµ akk (z) + degµ all (z))/2. since ρ ≡ 0. m}. .3. from which we conclude that deg b(z) ≤ 1. . we have B(1)k (z) = bk (z). . (11. . MULTI-FACTOR MODELS By assumption we can solve this linear equation for B and A. and thus Bi (z) and Aij (z) are polynomials in z of order less than or equal n. If n = 1 there is nothing more to prove. k. We finally have B(1)k +(1)l (z) = bk (z)zl + bl (z)zk + akl (z). .120 CHAPTER 11. . . We can relax the hypothesis on G in Theorem 11. (11.12) We may assume that akk ≡ 0. . Hence degl akl (z) ≤ 1. (11. and b and ρ satisfy a linear growth condition b(z) + ρ(z) ≤ C(1 + z ). . m}.

11.3. POLYNOMIAL TERM STRUCTURES Theorem 11.3.2 (Maximal Degree Problem II). Suppose that a(z)v, v ≥ k(z) v 2 , for some function k : Z → R+ with
z∈Z, z →∞

121

∀v ∈ Rm ,

(11.14)

lim inf k(z) > 0.

(11.15)

Then necessarily n ∈ {1, 2}. Conditions (11.14) and (11.15) say that a(z) becomes uniformly elliptic for z large enough. Proof. We shall make use of the basic inequality |z i | ≤ z This is immediate, since |z i | = z |i| Now define
N |i|

,

∀z ∈ Rm .
im

(11.16)

|z1 | z

i1

|zm | ··· z

≤ 1,

∀z ∈ Rm \ {0}.

Γk (x, z) :=
µ=1 N

Giµ (x) Giµ (x)
µ=1

∂z iµ ∂zk ∂ 2 z iµ . ∂zk ∂zl

(11.17)

Λkl (x, z) = Λlk (x, z) :=

(11.18)

Then (11.2) can be rewritten as (integration)
n m

|i|=0

(gi (x) − gi (0)) z =

i

bk (z)Γk (x, z)
k=1

+

1 akl (z) (Λkl (x, z) − Γk (x, z)Γl (x, z)) , 2 k,l=1 (11.19)

m

Suppose now that n > 2. We have from (11.17) Γk (x, z) =
|i|=n

Gi (x)ik z i−(1)k + · · · =: Pk (x, z) + · · · ,

122

CHAPTER 11. MULTI-FACTOR MODELS

where Pk (x, z) is a homogeneous polynomial in z of order n − 1, and · · · stands for lower order terms in z. By assumptions there exist x ∈ R+ and k ∈ {1, . . . , m} such that Pk (x, ·) = 0. Choose z ∗ ∈ Z \{0} with Pk (x, z ∗ ) = 0 and set zα := αz ∗ , for α > 0. Then we have zα ∈ Z and Γk (x, zα ) = αn−1 Pk (x, z ∗ ) + · · · , where · · · denotes lower order terms in α. Consequently, Γk (x, zα ) Pk (x, z ∗ ) = = 0. α→∞ zα n−1 z ∗ n−1 lim (11.20)

Combining (11.14) and (11.15) with (11.20) we conclude that L := lim inf
α→∞

1 zα
2n−2

a(zα )Γ(x, zα ), Γ(x, zα ) ≥ lim inf k(zα )
α→∞

Γ(x, zα ) 2 > 0. (11.21) zα 2n−2

On the other hand, by (11.19),
n

L≤

|i|=0

|gi (x) − gi (0)|

i |zα |

2n−2

+

b(zα ) zα

Γ(x, zα ) 1 a(zα ) + 2n−3 zα 2 zα 2

Λ(x, zα ) , zα 2n−4

for all α > 0. In view of (11.17), (11.18), (11.13) and (11.16), the right hand side converges to zero for α → ∞. This contradicts (11.21), hence n ≤ 2.

11.4

Exponential-Polynomial Families

We consider the Nelson–Siegel and Svensson families. For a discussion of general exponential-polynomial families see [8].

11.4.1

Nelson–Siegel Family
GN S (x, z) = z1 + (z2 + z3 x)e−z4 x .

Recall the form of the Nelson–Siegel curves

11.4. EXPONENTIAL-POLYNOMIAL FAMILIES

123

Proposition 11.4.1. There is no non-trivial diffusion process Z that is consistent with the Nelson–Siegel family. In fact, the unique solution to (11.2) is a(z) = 0, b1 (z) = b4 (z) = 0, b2 (z) = z3 − z2 z4 , b3 (z) = −z3 z4 .

The corresponding state process is Z1 (t) ≡ z1 , Z2 (t) = (z2 + z3 t) e−z4 t , Z3 (t) = z3 e−z4 t , Z4 (t) ≡ z4 , where Z(0) = (z1 , . . . , z4 ) denotes the initial point. Proof. Exercise.

11.4.2

Svensson Family
GS (x, z) = z1 + (z2 + z3 x)e−z5 x + z4 xe−z6 x .

Here the forward curve is

Proposition 11.4.2. The only non-trivial HJM model that is consistent with the Svensson family is the Hull–White extended Vasicek short rate model dr(t) = z1 z5 + z3 e−z5 t + z4 z −2z5 t − z5 r(t) dt + √ z4 z5 e−z5 t dW ∗ (t),

where (z1 , . . . , z5 ) are given by the initial forward curve f (0, x) = z1 + (z2 + z3 x)e−z5 x + z4 xe−2z5 x and W ∗ is some Brownian motion. The form of the corresponding state process Z is given in the proof below. Proof. The consistency equation (11.2) becomes q1 (x) + q2 (x)e−z5 x + q3 (x)e−z6 x + q4 (x)e−2z5 x + q5 (x)e−(z5 +z6 )x + q6 (x)e−2z6 x = 0, (11.22)

deg q5 deg q6 ≤ 3. z) =   0   (z2 x2 + z3 x3 )e−z5 x  0   x 0 ∂zi ∂zj GS (x. z5 + z6 = 0 and zi = 0 for all i = 1.124 CHAPTER 11. . z2 q2 (x) = a55 (z) 3 x4 + · · · . we assume for the moment that z5 = z 6 . z6 deg q4 . z) =  6    −x e   0 3 −z6 x z4 x e  x  − z15 e−z5 x + z15   − zx − z12 e−z5 x + z12  5 5 5  . .  z GS (x. z ∂z6 GS (x. Indeed. .2) are ∂x GS (x. . z) du =       0   0     0  2 −z x  . 6. Straightforward calculations lead to       z GS (u. . 1 1 x −z6 x + z2 − z6 − z 2 e  6 6  2z3 z3  z3 2 z2 z2 z2 2z3 −z5 x − z2 − z3  x + z5 + z 2 x + z 2 + z 3 e z5 5 5 5 5 5 z4 2 z x + 2z24 x + 2z34 e−z6 x − z4 3 z6 z z  6 6 6 q1 (x) = −a11 (z)x + · · · . MULTI-FACTOR MODELS for some polynomials q1 . q6 . (11.   1   e−z5 x   −z5 x   xe . z) = 0 for 1 ≤ i. . z5 z2 q3 (x) = a66 (z) 4 x4 + · · · .  z ∂z5 GS (x. .23) Then the terms involved in (11. . z) = (−z2 z5 + z3 − z3 z5 x)e−z5 x + (z4 − z4 z6 x)e−z6 x . z) =  −z6 x  xe   (−z2 x − z3 x2 )e−z5 x  −z4 x2 e−z6 x  0   −xe−z5 x   2 −z5 x   −x e . j ≤ 4. .

. Hence a1j (z) = aj1 (z) = a5j (z) = aj5 (z) = a6j (z) = aj6 (z) = 0 ∀j = 1 . deg q2 (x). .23) we know that the exponents −2z5 .4. . 1 q4 (x) = a22 (z) . If 2z5 = z6 then the condition q3 + q4 = q2 = 0 leads to a22 (z) = z4 z5 . EXPONENTIAL-POLYNOMIAL FAMILIES 125 where · · · stands for lower order terms in x. . Only a22 (z) is left as strictly positive candidate among the components of a(z). z6 Because of (11. . The remaining terms are q2 (x) = (b3 (z) + z3 z5 )x + b2 (z) − z3 − a22 (z) + z 2 z5 . Hence b1 (z) = a3j (z) = aj3 (z) = a4j (z) = aj4 (z) = 0 ∀j = 1. b3 (z) = −z5 z3 . b4 (z) = −2z5 z4 . 6. But a is a positive semi-definite symmetric matrix. z5 while q1 = q5 = q6 = 0. We are left with q1 (x) = b1 (z). . expression (11.23) we conclude that a11 (z) = a55 (z) = a66 (z) = 0. + z5 z6 1 q6 (x) = a44 (z) x2 + · · · .22) simplifies considerably. z5 q3 (x) = (b4 (z) + z4 z6 )x − z4 . q4 (x) = a33 (z) 1 2 x +··· . z5 1 1 q5 (x) = a34 (z) x2 + · · · . .11. If 2z5 = z6 then also a22 (z) = 0. Taking this into account. Because of (11. b2 (z) = z3 + z4 − 25 z2 . −(z5 + z6 ) and −2z6 are mutually different. 6. deg q3 ≤ 1.

Z(t)) = z1 + Z2 (t) satisfies dr(t) = z1 z5 + z3 e−z5 t + z4 z −2z5 t − z5 r(t) dt + √ z4 z5 e−z5 t dW ∗ (t). By continuity of a(z) and b(z) in z. Z4 (t) = z4 z −2z5 t and d dZ2 (t) = z3 e−z5 t + z4 z −2z5 t − z5 Z2 (t) dt + ρ2j (t) dWj (t). the above results thus extend for all z ∈ Z. Hence the corresponding short rate process r(t) = GS (0. writing shortly zi = Zi (0). In that case we have. In particular. MULTI-FACTOR MODELS We derived the above results under the assumption (11. Z5 and Z6 are even constant. Z1 . since a(z) = 0 if 2z5 = z6 . we only have a non-trivial process Z if Z6 (t) ≡ 2Z5 (t) ≡ 2Z5 (0). all Zi ’s but Z2 are deterministic.126 CHAPTER 11.23) holds is dense Z. 2j j=1 By L´vy’s characterization theorem we have that e d W ∗ (t) := j=1 0 t √ ρ2j (s) dWj (s) z4 z5 e−z5 s is a real-valued standard Brownian motion (→ exercise). . Z1 (t) ≡ z1 . Z3 (t) = z3 e−z5 t . But the set of z where (11. j=1 where ρ2j (t) (not necessarily deterministic) are such that d ρ2 (t) = a22 (Z(t)) = z4 z5 e−2z5 t .23). Thus.

8)) d P (t. The breakthrough came 1997 with the publications of Brace–Gatarek– Musiela [5] (BGM). the forward δ-period LIBOR for the future date T prevailing at time t is the simple forward rate L(t. Recall that. T )/P (t. Because of this they are usually referred to as “market models”.T +δ (t) dW T +δ (t). T ) P (t. T + δ) 127 . There has been some effort in the years after the publication of HJM [9] in 1992 to develop arbitrage-free models of other than instantaneous. continuously compounded rates. T ) −1 . The principal idea of both approaches is to chose a different numeraire than the risk-free account (the latter does not even necessarily have to exist). T + δ) = P (t. P (t. To start with we consider the HJM setup. P (t. such as LIBOR. as we have seen. directly. and Jamshidian [12]. One may want to model other rates. who succeeded to find a HJM type model inducing lognormal LIBOR rates. Both approaches lead to Black’s formula for either caps (LIBOR models) or swaptions (swap rate models).Chapter 12 Market Models Instantaneous forward rates are not always easy to estimate. T + δ) = 1 δ P (t. T + δ) is a martingale for the (T + δ)-forward measure QT +δ . for a fixed δ (typically 1/4 = 3 months). In particular (see (9. T ) σT. T + δ) We have seen in Chapter 9 that P (t. who developed a framework for arbitrage-free LIBOR and swap rate models not based on HJM. T. T ) = F (t. as in Chapter 9.

T ) − κ)+ | Ft ± 1 2 T t λ(s. T ) − κ)+ | Ft = δP (t. T ) conditional on Ft is Gaussian with mean 1 log L(t. T ) 2 ds 1 2 2 ds . T ) dW T +δ (u) − 1 2 t λ(u. T ))) . T ) exp s λ(u. δ Now suppose there exists a deterministic Rd -valued function λ(t. we get dL(t. T ) σT. T )λ(t. settlement date T + δ and strike rate κ is thus EQ e − T +δ 0 r(s) ds = P (t. T ) s 2 du . T + δ) (L(t. T ) = L(s. T + δ) 1 = (δL(t. T ) t 2 ds λ(s. T ). T ) + 1)σT. The time t price of a caplet with reset date T .T +δ (t) dW T +δ (t). T ) such that δL(t. T ) = L(t. Hence the QT +δ -distribution of log L(T.2 (t. where log d1. T ) 2 ds.128 Hence dL(t. T ) .T ) κ T t δ(L(T. (12. T )Φ(d1 (t. T + δ) δ P (t. T ) = CHAPTER 12. λ(s. T ) dW T +δ (t). T + δ)EQT +δ δ(L(T. T ) d σT. T ) := L(t.T +δ (t) = λ(t. T )) − κΦ(d2 (t. which is equivalent to t L(t.1) δL(t. T ) − 2 and variance t T T λ(s. MARKET MODELS P (t. for s ≤ t ≤ T .T +δ (t) dW T +δ (t) = δ P (t. T ) 1 1 P (t. T ) + 1 Plugging this in the above formula.

Z[27](Section 4. T ) t 2 ds. but the construction and proof are not easy. using the definition of σT. T ))e− T +δ T f (t. as introduced in Section 2. This is just Black’s formula for the caplet price with σ(t)2 set equal to 1 T −t T λ(s.u) du T +δ T λ(t. T ) = 0 for T ∈ [0. Section 5.12. + 1 − e− f (t. 12. T + δ) = σ(t. T ) + (f (t. But do such HJM models exist? The answer is yes.T +δ (t). In a sense.1.1 Models of Forward LIBOR Rates → MR[19](Chapter 14). u) du = 1 − e− T +δ T f (t. MODELS OF FORWARD LIBOR RATES 129 and Φ is the standard Gaussian CDF. see also [8. Instead of the risk neutral martingale measure we will work under forward measures. we place ourselves outside of the HJM framework (although HJM is often implicitly adopted).7) There is a more direct approach to LIBOR models without making reference to continuously compounded forward and short rates.1) yields Black’s formula for caplet prices. T ) ∂T λ(t. Now it has to be proved that the corresponding HJM equations for the forward rates have a unique and well-behaved solution.1).6]. δ) (typically. The idea is to rewrite (12. the numeraires accordingly being bond price processes.u) du λ(t.u) du This is a recurrence relation that can be solved by forward induction. Differentiating in T gives σ(t. This all has been carried out by BGM [5]. This gives a complicated dependence of σ on the forward curve. once σ(t. T + δ) − f (t.6! We have thus shown that any HJM model satisfying (12. σ(t. T ). ·) is determined on [0. as (→ exercise) T +δ T σ(t. T ). . δ)).

Tm ).TM (t) := δL(t. TM −1 ) + 1 t ∈ [0. . TM ) t ∈ [0. TM −1 )λ(t. TM ]. P (0. Now define the bounded (why?) Rd -valued process σTM −1 . (Ft )t∈[0. an Rd -valued. T We are going to construct a model for the forward LIBOR rates with maturities T1 . . M. m = 0. . .1 Discrete-tenor Case We fix a finite time horizon TM = M δ. TM ) which is of course equivalent to L(t. m = 0. Tm+1 ) m = 0. t ∈ [0. TM −1 ) λ(t. . . Write Tm := mδ. F . δL(t. . Tm ) −1 . 1 P (0. . bounded. TM −1 ]. t ∈ [0. TM −1 ) · W TM .130 CHAPTER 12. MARKET MODELS 12. We proceed by backward induction and postulate first that dL(t. and a probability space (Ω. TM −1 ) − 1 Et λ(·. deterministic function λ(t. for some M ∈ N.1. TM −1 ) dW TM (t). . . P (0. M − 1. . TM −1 . TM −1 ]. and hence strictly positive initial forward LIBOR rates L(0. Tm ). QTM ). The notation already suggests that QTM will play the role of the TM -forward measure. which represents the volatility of L(t. Tm ]. . . Tm ). . • an initial strictly positive and decreasing discrete term structure P (0. .TM ] . where Ft = FtW M is the filtration generated by a d-dimensional Brownian motion W TM (t). TM −1 ). . TM −1 ) = L(t. . We take as given: • for every m ≤ M − 1. TM −1 ) −1 L(0. TM −1 ) = δ P (0. M. TM −1 ) = 1 δ P (0. Tm ) = 1 δ P (0.

TM −1 ) and define the bounded Rd -valued process σTM −2 .TM −1 (s) ds. dQTM −1 and the QTM −2 -Brownian motion t W TM −2 (t) := W TM −1 (t) − 0 σTM −2 .1). TM −2 ]. TM −2 ) + 1 t ∈ [0. This induces an equivalent probability measure QTM −1 ∼ QTM on FTM −1 via dQTM −1 = ETM −1 σTM −1 . TM −2 ].TM −1 (t) := δL(t.TM (s) ds. TM −2 ) dW TM −1 (t). TM −2 ]. P (0. P (0. TM −2 ) − 1 Et λ(·. Hence we can postulate 0 σTM −1 .12. TM −2 ) L(0. TM −2 ). 1 P (0. TM −1 ].TM −1 · W TM −1 . Repeating this procedure leads to a family of log-normal martingales (L(t.1. yielding an equivalent probability measure QTM −2 ∼ QTM −1 on FTM −2 via dQTM −2 = ETM −2 σTM −2 . . TM −2 ) · W TM −1 .Tm ] under their respective measures QTm . TM −2 ) λ(t. TM −2 ) = 1 δ t ∈ [0. TM −2 ) = −1 . Tm ))t∈[0. TM −2 ) = L(t.TM · W TM . t ∈ [0. δL(t. TM −2 )λ(t. L(t. dQTM and by Girsanov’s theorem t W TM −1 (t) := W TM (t) − is a QTM −1 -Brownian motion. dL(t. δ P (0. TM −1 ) that is. MODELS OF FORWARD LIBOR RATES 131 compare with (12. t ∈ [0.

Tm−1 ) P (t. . Tm−1 ]. Tm ) t ∈ [0. Tm ) which is a QTm -martingale. Tm−1 ]. we then can define the forward price process P (t. Tm−1 ) = Et σTm−1 . Tm−1 ) m=i+1 δL(Ti . Tm−1 ) + 1 m=i+1 j j t ∈ [0. for 0 ≤ i < j ≤ m. P (t. Tm ) P (0. Tm ) = δ dL(t. . LIBOR Dynamics under Different Measures We are interested in finding the dynamics of L(t. MARKET MODELS What about bond prices? For all m = 1. The knowledge of forward LIBOR rates for all maturities T ∈ [0. Tm ) under any of the forward measures QTk . Tm−1 ) σTm−1 . P (t. Tm−1 )λ(t. Tm ) Since d P (t.Tm · W Tm . Tm−1 ) = δL(t. Tm−1 ) P (0. Tm ) = . P (Ti . . . From this we can derive.2) However.Tm (t) dW Tm (t) P (t. P (t. Tj ) = P (Ti . Tm−1 ) dW Tm (t) = we get that P (t. Tm ) in the discrete-tenor model of forward LIBOR rates. Tm−1 ) := δL(t. 1 P (Ti . . TM −1 ] is necessary. (12.132 Bond Prices CHAPTER 12. Tm−1 ) + 1. it is not possible to uniquely determine the continuous time dynamics of a bond price P (t. M .

0 ≤ j ≤ m. since we know P (t. l=i 0 t ∈ [0.1. Tk+1 ) P (t. Ti ]. Tm ) under QTk is given according to the three cases k <m+1: k =m+1: k >m+1: dL(t. Tk ) P (t. Tn ) for all m < n ≤ M (strictly speaking. this formula makes sense only for t = Tj . . Then its price π(t) at t ≤ Tm is given by π(t) = P (t. Tm )dW Tk (t). Tm ) · L(t. Tm ) = −λ(t. Let 0 ≤ m ≤ M − 1 and 0 ≤ k ≤ M . Tn ) only for such t). Tm ) · L(t. Tk ) dQTk | = Et σTk . P (Tm . Tn )EQTn | Ft . Tm ) dW Tm+1 (t). m ≤ M . Tm ) = λ(t.Tk+1 · W Tk+1 = . Then the dynamics of L(t. Tk ]. Tk+1 Ft dQ P (0. This follows from the equality j−1 t W (t) = W (t) − for all 1 ≤ i < j ≤ M . Tm ) = λ(t. Here is a useful formula. Tm ) dL(t. Tm ) k−1 σTl . Proof.1.1. Notice that P (0.Tl+1 (t) dt + λ(t. MODELS OF FORWARD LIBOR RATES 133 Lemma 12. L(t. which can be combined with (12.Tl+1 (s) ds. Let X ∈ L1 (QTm ) be a Tm -contingent claim. Derivative Pricing Ti Tj σTl . l=m+1 for t ∈ [0.1. l=k dL(t.12. Tk ∧ Tm ]. Tk+1 ) t ∈ [0. Lemma 12. Tm ) m σTl . Tm )EQTm [X | Ft ] X = P (t.2).2. Tm ) dW Tk (t).Tl+1 (t)dt + λ(t. Proof.

since the first equality was derived in Proposition 9. . . Tm ) P (t. Tm ) = λ(t. . . Tµ ).Tl+1 (t) we have o m d log L(t. we assumed there the existence of a savings account. Tm ) − K)  . Tl ) − λ(t.1 makes it clear that (9. L(Tµ . Tk+1 ) P (t. MARKET MODELS dQTm dQTk P (0. strike rate K. But even if there is no risk neutral but only forward measures. . Tµ+1 . Tm ) . maturity Tµ and underlying tenor Tµ . . Tm ) dW Tµ (t). for some positive integers µ < ν ≤ M . Tm )(L(Tµ .3) is the arbitrage-free price of X). Tµ )EQTµ  m=µ P (Tµ . Notice that by Lemma 12.134 Hence CHAPTER 12. P (0. Its payoff at maturity is ν−1 + δ m=µ P (Tµ . This cannot be done analytically anymore. Tk ) | = | = Tk+1 Ft Tn F t dQ dQ P (0. Tm )(L(Tµ .1. so one has to resort to numerical procedures. Itˆ’s formula and the definition of σTl . the reasoning in Section 9. Tl ) λ(t.2 (strictly speaking. Tm ) − K) . under the measure QTµ . Tn ) n−1 n−1 Bayes’ rule now yields the assertion. Tm ) · l=µ 1 δL(t. Tν (Tµ is the first reset date and Tν the maturity of the underlying swap). Tµ+1 ). Tm ) δL(t.1. Swaptions Consider a payer swaption with nominal 1. Tk ) P (t. Tn ) P (t. L(Tµ . . Tν−1 ) π(0) = δP (0. . Tl ) + 1 2 2 dt + λ(t. The swaption price at t = 0 (for simplicity) therefore  ν−1 + To compute π(0) we thus need to know the joint distribution of L(Tµ . Tk+1 ) k=m k=m = P (0. We sketch here the Monte Carlo method.1. .

12.1. MODELS OF FORWARD LIBOR RATES

135

for t ∈ [0, Tµ ] and m = µ, . . . , ν − 1. Write α(t, Tm ) for the above drift term, i and let ti = n Tµ , i = 0, . . . , n, n ∈ N large enough, be a partition of [0, Tµ ]. Then we can approximate
ti+1 ti+1

log L(ti+1 , Tm ) = log L(ti , Tm ) +
ti

α(s, Tm ) ds +
ti

λ(s, Tm ) dW Tµ (s)

≈ log L(ti , Tm ) + α(ti , Tm ) where ζm (i) :=
ti ti+1

1 + ζm (i), n

λ(s, Tm ) dW Tµ (s),

such that ζ(i) = (ζµ (i), . . . , ζν−1 (i)), i = 0, . . . , n − 1, are independent Gaussian (ν − µ)-vectors with mean zero and covariance matrix
ti+1

Cov[ζk (i), ζl (i)] =
ti

λ(s, Tk ) · λ(s, Tl ) ds,

which can easily be simulated. Forward Swap Measure We consider the above payer swap with reset dates Tµ , . . . , Tν−1 and cashflow dates Tµ+1 , . . . , Tν (= maturity of the swap). The corresponding forward swap rate at time t ≤ Tµ is
P (t,Tν 1 − P (t,Tµ ) P (t, Tµ ) − P (t, Tν ) ) Rswap (t) = . = ν P (t,Tk ) δ ν P (t, Tk ) δ k=µ+1 P (t,Tµ ) k=µ+1

(12.3)

Since for any 0 ≤ l < m ≤ M P (t, Tl ) P (t, Tl ) P (t, Tm−1 ) = ··· = P (t, Tm ) P (t, Tl+1 ) P (t, Tm )
m−1

(1 + δL(t, Ti )) ,
i=l

Rswap (t) is given in terms of the above constructed LIBOR rates. Define the positive QTµ -martingale D(t) := P (t, Tk ) , P (t, Tµ ) k=µ+1
ν

t ∈ [0, Tµ ].

136

CHAPTER 12. MARKET MODELS

This induces an equivalent probability measure Qswap ∼ QTµ , the forward swap measure, on FTµ by D(Tµ ) dQswap = . Tµ dQ D(0) Lemma 12.1.3. The forward swap rate process Rswap (t), t ∈ [0, Tµ ], is a Qswap -martingale. Proof. Let 0 ≤ m ≤ M and 0 ≤ s ≤ t ≤ Tm ∧ Tµ . Then EQswap P (t, Tm ) 1 P (t, Tm ) | Fs = E Q Tµ D(t) | Fs P (t, Tµ )D(t) D(s) P (t, Tµ )D(t) 1 P (s, Tm ) = . D(s) P (s, Tµ )

Now the lemma follows (set m = 0, µ) by (12.3). The payoff at maturity of the above swaption can be written as δD(Tµ ) (Rswap (T0 ) − K)+ . Hence the price is π(0) = δP (0, Tµ )EQTµ D(Tµ ) (Rswap (T0 ) − K)+ = δP (0, Tµ )D(0)EQswap (Rswap (T0 ) − K)+
ν k=µ+1

P (0, Tk )EQswap (Rswap (T0 ) − K)+ .

Lemma 12.1.3 tells us that Rswap is a positive Qswap -martingale and hence of the form dRswap (t) = Rswap (t)ρswap (t) dW swap(t), t ∈ [0, Tµ ],

for some Qswap -Brownian motion W swap and some swap volatility process ρswap . Hence, under the hypothesis (H) ρswap (t) is deterministic,

12.1. MODELS OF FORWARD LIBOR RATES

137

we would have that log Rswap (Tµ ) is Gaussian distributed under Qswap with mean 1 Tµ swap ρ (t) 2 dt log Rswap (0) − 2 0 and variance
0 Tµ

ρswap (t)

2

dt.

The swaption price would then be
ν

π(0) = δ
k=µ+1

P (0, Tk ) (Rswap (0)Φ(d1 ) − KΦ(d2 )) ,
Rswap (0) K Tµ 0 Tµ 0

with log d1,2 :=

±

1 2

ρswap (t)
2

2

dt .

ρswap (t)

dt

1 2

This is Black’s formula with volatility σ 2 given by 1 Tµ
Tµ 0

ρswap (t)

2

dt.

However, one can show that ρswap cannot be deterministic in our lognormal LIBOR setup. So hypothesis (H) does not hold. For swaption pricing it would be natural to model the forward swap rates directly and postulate that they are log-normal under the forward swap measures. This approach has been carried out by Jamshidian [12] and others. It could be shown, however, that then the forward LIBOR rate volatility cannot be deterministic. So either one gets Black’s formula for caps or for swaptions, but not simultaneously for both. Put in other words, when we insist on log-normal forward LIBOR rates then swaption prices have to be approximated. One possibility is to use Monte Carlo methods. Another way (among many others) is now sketched below. We have seen in Section 2.4.3 that the forward swap rate can be written as weighted sum of forward LIBOR rates
ν

Rswap (t) =
m=µ+1

wm (t)L(t, Tm−1 ),

Tm ) = wm (t) = D(t)P (t. Tl−1 )λ(t. ρswap (s) t ∈ [0. Tl−1 ) . Tµ ) CHAPTER 12. 2 Rswap (0) k.Tm−1 ) 1+δL(t.l=µ+1 ν Denote the square root of the right hand side by ρswap (t). Tk−1 )L(t. log Rswap t dt ν wk (0)wl (0)L(t.Tµ ) · · · 1+δL(t. m=µ+1 t ∈ [0. Tm−1 ) dW Tµ . and define the ˜ swap Q -Brownian motion (L´vy’s characterization theorem) e W ∗ (t) := t d 0 j=1 ρswap (s) j dWjswap (s). We thus approximate wm (t) by its deterministic initial value wm (0). such that the quadratic variation of log Rswap (t) becomes approximatively deterministic ρ swap (t) 2 ≈ wk (0)wl (0)L(0. According to empirical studies. So that ν Rswap (t) ≈ wm (0)L(t. Tm−1 )λ(t.138 with weights P (t. the variability of the wm ’s is small compared to the variability of the forward LIBOR rates. Tk−1 ) · λ(t. m=µ+1 and hence. Tm−1 ).Tµ ) ν 1 1 j=µ+1 1+δL(t. Tl−1 )λ(t. Tµ ]. Tk−1 ) · λ(t. Tk−1 )L(0. Tµ ]. under the Tµ -forward measure QTµ ν dRswap (t) ≈ (· · · ) dt + wm (0)L(t.l=µ+1 In a further approximation we replace all random variables by their time 0 values. We obtain for the forward swap volatility ρswap (t) 2 = d log Rswap .Tj−1 ) . MARKET MODELS 1 1 · · · 1+δL(t. Tl−1 ) . ≈ 2 Rswap (t) k. .

. B ∗ (Tm ) := (1 + δL(Tm−1 . B ∗ is a strictly increasing and predictable process with respect to the discrete-time filtration (FTm ).12. since it originally appears in his book R[22]. M − 1. ρ 139 Hence we can approximate the swaption price in our log-normal forward LIBOR model by Black’s swaption price formula where σ 2 is to be replaced by 1 Tµ Tµ 0 ν k.4. B ∗ (Tn ) = B ∗ (Tm ) k=m ∗ 1 . . . P (Tm . . . 2 Rswap (0) This is “Rebonato’s formula”. see BM[6](Chapter 8). that is. n−1 m = 1.l=µ+1 wk (0)wl (0)L(0. for all i = 0. Tk−1 ) · λ(t. Tk+1 ) m < n ≤ M.1. that is. TM ) . Tl−1 ) dt. . By construction. Hence B (Tm ) can be interpreted as the cash amount accumulated up to time Tm by rolling over a series of zero-coupon bonds with the shortest maturities available. The goodness of this approximation has been tested numerically by several authors. They conclude that “the approximation is satisfactory in general”. Tm−1 ))B ∗ (Tm−1 ). we can define the discrete-time. M . . Tl−1 )λ(t. .1. . Implied Savings Account Given the LIBOR L(Ti . implied savings account process B ∗ (0) := 1. M. . . Tk−1 )L(0. For all 0 ≤ m ≤ M we have EQTM [B ∗ (TM ) | FTm ] = B ∗ (Tm ) . P (Tk . . for all m = 1. Ti ) for period [Ti . Ti+1 ]. B ∗ (Tm ) is FTm−1 -measurable. Lemma 12. MODELS OF FORWARD LIBOR RATES Then we have dRswap (t) = Rswap (t) ρswap (t) dW ∗ (t) ≈ Rswap (t)˜swap (t) dW ∗ (t).

(12. TM −1 ]..1. dQTM Q∗ can be interpreted as risk neutral martingale measure since P (Tk . MARKET MODELS EQTM [B ∗ (TM )P (0. for T ∈ [0. T ). we now need a continuum of initial dates: .4) shows that for any 0 ≤ l ≤ M the discrete-time process P (Tk . In addition. TM ) Hence (Bayes again) EQ ∗ E Q TM B ∗ (Tk ) | F Tk = B ∗ (Tl ) B ∗ (Tk ) B ∗ (Tl ) B ∗ (Tl ) P (Tl . The stochastic basis is the same as before. Given the discrete-tenor skeleton constructed in the previous section. = B ∗ (Tm ) TM F T m dQ P (Tm . B ∗ (Tl ) 0 ≤ k ≤ l ≤ M.2 Continuous-tenor Case We now specify the continuum of all forward LIBOR rates L(t. Exercise.4 we have for m ≤ M dQ∗ P (0. TM ) | . so that we can define the equivalent probability measure Q∗ ∼ QTM on FTM by dQ∗ = B ∗ (TM )P (0. T ) will follow a lognormal process under the forward measure for the date T + δ.. Lemma 12. Tl ) = EQ∗ B ∗ (Tk ) | F Tk .140 Proof.TM ) k) P (Tk .4 yields in particular CHAPTER 12. which proves (12..1. k=0. TM )] = 1 and B ∗ (TM )P (0. TM ) > 0.4). Each forward LIBOR rate L(t. (12. it is enough to fill the gaps between the Tj s.. Put in other words. Tl ). TM ).1.4) Indeed.l 12. in view of Lemma 12. Tl ) B ∗ (Tk ) is a Q∗ -martingale with respect to (FTk ).TM ) B ∗ (T | F Tk = P (Tk .

as in the previous section. we focus on the forward measures for dates T ∈ [TM −1 . T ) B we can define the T -forward measure QT ∼ Q∗ on FT by dQT 1 . T ∈ [0.1. Since (→ exercise) B ∗ (T ) is FT -measurable. strictly positive and 1 EQ ∗ =1 ∗ (T )P (0. T ) = EQ∗ 1 B ∗ (T ) . t ∈ [0. First. dQTM dQ∗ dQTM B ∗ (T )P (0. TM −1 ]. 1] with α(TM −1 ) = 0 and α(TM ) = 1. T ]. TM ]. deterministic function λ(t. TM ) dQT = = . Tm ). and hence an initial strictly positive forward LIBOR curve L(0. such that log B ∗ (T ) := (1 − α(T )) log B ∗ (TM −1 ) + α(T ) log B ∗ (TM ) satisfies P (0. . T ) . However. T ) −1 . = ∗ ∗ dQ B (T )P (0. T ) Then we have dQT dQ∗ B ∗ (TM )P (0. . T ). which represents the volatility of L(t. T ). Second. M − 1. MODELS OF FORWARD LIBOR RATES 141 • for every T ∈ [0. we are given the values of the implied savings account B ∗ (TM −1 ) and B ∗ (TM ) and the probability measure Q∗ . . TM −1 ]. • an initial strictly positive and decreasing term structure P (0. T ). TM ]. TM ]. We do not have to take into account forward LIBOR rates for these dates. TM ] → [0. Let T ∈ [TM −1 . T ) = 1 δ P (0. since they are not defined there. ∀T ∈ [TM −1 . TM ]. an Rd -valued.12. we construct a discrete-tenor model for L(t. P (0. T + δ) T ∈ [0. By monotonicity there exists a unique deterministic increasing function α : [TM −1 . m = 0. bounded. .

TM · W TM . for any T ∈ [TM −2 . 1 P (0. is a QT -Brownian motion. TM ] was arbitrary.TM · W TM = Et σT. T ) for any T ∈ [TM −2 . T ) dW T +δ (t). T ].TM (s) 0 2 ds = Et σT. The forward measures for T ∈ [TM −2 .T +δ · W T +δ Et σT +δ. for t ∈ [0. T ) t = exp 0 σT. TM ) |F t = E Q T M | Ft dQTM B ∗ (T )P (0. T ) L(0.TM ∈ L such that (→ exercise) dQT B ∗ (TM )P (0. T ) = L(t. Third. TM −1 ].T +δ · W T +δ . T ].T +δ (t) := δL(t. . T ]. T ). 0 t ∈ [0. T )λ(t. Girsanov’s theorem tells us that t W T (t) := W TM (t) − σT.TM (s) dW TM (s) − 1 2 t σT. TM −1 ] are now given by dQT = ET σT. since T ∈ [TM −1 . t ∈ [0. δL(t. T + δ) This in turn defines the positive and bounded process σT. δ P (0.TM (s) ds. T ) = −1 . MARKET MODELS By the representation theorem for QTM -martingales there exists a unique σT.142 CHAPTER 12. T ) + 1 t ∈ [0. T ) λ(t. TM −1 ] as dL(t.TM · W TM . T +δ dQ Hence we have (→ exercise) dQT dQT +δ dQT |F t = |F t |F dQTM dQT +δ dQTM t = Et σT. we can now define the forward LIBOR process L(t. T ].

Indeed. it is reasonable to define (why?) the forward price process T P (t. S) dQS = |F t |F P (0. S) = P (0. we obtain the zero-coupon bond prices for all maturities. S) Et −σT.TM . S) P (0. 143 Proceeding by backward induction yields the forward measure QT and Q -Brownian motion W T for all T ∈ [0. Hence even though all δ-period forward LIBOR rates L(t. TM ].TM := σT. S) may be greater than 1. t ∈ [0. T ) where (→ exercise) σT. there may be negative interest rates for other than δ periods. T ]. = P (0. In particular.S := σT. MODELS OF FORWARD LIBOR RATES for any T ∈ [TM −2 . where σT. S) dQS := |F P (t.TM .12. for t = T we get P (T. and forward LIBOR rates L(t. for any 0 ≤ T ≤ S ≤ TM . T ) dQTM dQT t P (0. . S) ET −σT. TM −1 ]. TM −1 ].T +δ + σT +δ.S · W T . T ) are positive. This way. T ) dQT t dQTM P (0.1.TM − σS. T ) Notice that now P (T. P (0. T ) P (0. T ) for all T ∈ [0.S · W T . unless S − T = mδ for some integer m.

144 CHAPTER 12. MARKET MODELS .

This may be the case for treasury bonds. T ) had the property that P (T. 145 .1 Transition and Default Probabilities There are three main approaches to the modelling of transition and default probabilities: • Historical method: rating agencies determine default and transition probabilities by counting defaults that actually occurred in the past for different rating classes. [1]. For the modelling of credit risk we have to consider the following risk elements: • Default probabilities: probability that the debtor will default on its obligations to repay its debt. Chapter 2]. That is. the payoff was certain. • Transition probabilities: between credit ratings (credit migration). which is reflected by a higher yield on the bond.Chapter 13 Default Risk → [24. Usually one has to model objective (for the rating) and risk-neutral (for the pricing) probabilities. etc. Investors should be adequately compensated by a risk premium. T ) = 1. 13. • Recovery rates: proportion of value delivered after default has occurred. Corporate bonds however may bear a substantial risk of default. So far bond price processes P (t. there was no risk of default of the issuer.

is trR. The formal definition of default and transition rates is the following.1. We briefly discuss the first two approaches in this section. Goes back to Merton (1974) [18].2 below. • Intensity based method: default is specified exogenously by a stopping time with given intensity process. based on the time frame [Y0 . The historical one-year transition rate from rating R to R .R (y) . objective information and credit analysis of obligors. the rating agency regularly checks and adjusts the rating. Y1 y=Y0 NR (y) . The number of Moody’s rated obligors has increased from 912 in 1960 to 3841 in 1997.R := Y1 y=Y0 MR. After issuance and assignment of the initial obligor’s rating.146 CHAPTER 13. for an R-rated issuer is dR := Y1 y=Y0 MR (y) .1.1. Y1 ]. The historical one-year default rate. the obligor is set on the Rating Review List (Moody’s) or the Credit Watch List (S&P). If there is a tendency observable that may affect the rating. Usually they operate without government mandate and are independent of any investment banking firm or similar organization. 1. Y1 ]. Among the biggest US agencies are Moody’s Investors Service and Standard&Poor’s (S&P). DEFAULT RISK • Structural approach: models the value of a firm’s assets. Y1 NR (y) y=Y0 where NR (y) is the number of issuers with rating R at beginning of year y.1 Historical Method Rating agencies provide timely. Default is when this value hits a certain lower bound. The intensity based method is treated in more detail in Section 13. based on the time frame [Y0 . 2. 13. Definition 13. and MR (y) is the number of issuers with rating R at beginning of year y which defaulted in that year.

The historical method has several shortcomings: • It neglects the default rate volatility.1: Rating symbols. . TRANSITION AND DEFAULT PROBABILITIES Table 13. Transition and default probabilities are dynamic and vary over time.2. S&P AAA AA+ AA AAA+ A ABBB+ BBB BBBBB+ BB BBB+ B BCCC+ CCC CCCCC C D Moody’s Interpretation Investment-grade ratings Aaa Highest quality.1. Transition rates are gathered in a transition matrix as shown in Table 13. depending on economic conditions. extremely strong Aa1 Aa2 High quality Aa3 A1 A2 Strong payment capacity A3 Baa1 Baa2 Adequate payment capacity Baa3 Speculative-grade ratings Ba1 Likely to fulfill obligations Ba2 ongoing uncertainty Ba3 B1 B2 High risk obligations B3 Caa1 Caa2 Current vulnerability to default Caa3 Ca In bankruptcy or default or other marked shortcoming 147 where NR (y) is as above.13.R (y) is the number of issuers with rating R at beginning of year y and R at the end of that year. and MR.

46 1.26 • It neglects cross-country differences and business cycle effects. .66 5.24 0. Rating at end of year (R ) A BBB BB B Initial rating (R) AAA AA A BBB BB B CCC AAA AA CCC D 93. The obligor (=the firm) defaults by T if the total market value of its assets V (T ) at T is less than its liabilities X.66 83.46 5.09 0.91 10.1.23 7. and hence underestimation of trR.03 0.03 0.01 0.72 6. There is a systematic overestimation of trR.32 0. DEFAULT RISK Table 13.R for some R = R .83 0.44 0.00 0.00 0.T ] .44 6.49 0.01 0.00 0.02 0. Ratings Performance 2000.05 1. 13.20 0.16 0.148 CHAPTER 13. based on the time frame [1980.08 0.com/Articles/Investment/ARTINV00000692000Ratings.00 0. T ) = P [V (T ) < X | Ft ] . T ]. V (t) t ∈ [0. F .28 61.00 0. • Rating agencies react too slow to change ratings.10 0.07 2.15 0.04 0.81 0.06 0. Thus the probability of default by time T conditional on the information available at t ≤ T is pd (t.94 0.49 0.40 0.88 1.83 89.pdf). see http://financialcounsel.2000] (Standard&Poor’s.72 83.29 0.94 0.18 0.23 25.2 Structural Approach Merton [18] proposed a simple capital structure of a firm consisting of equity and one type of zero coupon debt with promised terminal constant payoff X > 0 at maturity T .26 4. The dynamics of V (t) is modelled as geometric Brownian motion dV (t) = µ dt + σ dW (t). (Ft )t∈[0.25 91. P).2: S&P’s one-year transition and default rates. with respect to some stochastic basis (Ω.24 4.R and dR .66 91.03 0.76 5.09 0.62 3.06 0.84 5.

It is clear that the distribution of log V (T ) conditional on Ft and N (T ) − N (t) = n is Gaussian with mean log V (t) + mn + µ − and variance nρ2 + σ 2 (T − t).  1 − µ − 2 σ 2 (T − t) . + the instantaneous probability of default (∂T pd (t. N and Zj are mutually independent. Z2 . A dynamic description of V is t N (t) V (t) = V (0) + 0 V (s) (µ ds + σ dW (s)) + j=1 V (τj −) eZj − 1 . TRANSITION AND DEFAULT PROBABILITIES that is 1 V (T ) = V (t) exp σ(W (T ) − W (t)) + µ − σ 2 (T − t) .d. . T ]. Zhou (1997) models V (t) as jump-diffusion process  N (T ) V (T ) = V (t)  j=N (t)+1 e Zj  e  µ− σ 2 2 (T −t)+σ(W (T )−W (t)) . as in the Merton approach. are the jump times of N . ρ2 ) distributed random variables. . where τ1 . is a sequence of i. T ]. To include “unexpected” defaults one has to consider firm value processes with jumps. .i. √ σ T −t t ∈ [0.1. T )|T =t ) is zero. . 2 Then we have pd (t. . It is assumed that W . If the firm value process V (t) is continuous. τ2 .13. Gaussian N (m. T ) = Φ   log X V (t) 149 t ∈ [0. σ2 2 (T − t) . . where N (t) is a Poisson process with intensity λ and Z1 .

T ) without defining the exact default event. Formally. The Ft -conditional default probability is now pd (t. such that Td = inf{t | V (t) ≤ X(t)}. In this case the conditional default probability is pd (t. T ]. The precise conditions under which it must occur (such as hitting a barrier) are easily misspecified. t ∈ [0. 13. In this section we focus directly on describing the evolution of the default probabilities pd (t. T ]. n  e−λ(T −t) (λ(T − t)) n! which can be determined by Monte Carlo simulation.150 Hence the conditional default probability pd (t. DEFAULT RISK P [log V (T ) < log X | Ft . hence the right-continuous default process H(t) := 1{Td ≤t} is (Ft )-adapted. The default time Td is assumed to be an (Ft )-stopping time.2 Intensity Based Method Default is often a complicated event. F . The flow of the complete market information is represented by a filtration (Ft ) satisfying the usual conditions. T ) = P [Td ≤ T | Ft ] . P). N (T ) − N (t) = n] P [N (T ) − N (t) = n] Φ  log X V (t) = − mn − µ − σ2 2 (T − t) nρ2 + σ 2 (T − t)  First passage time models make this approach more realistic by admitting default at any time Td ∈ [0. T ) = E [H(T ) | Ft ] . T ) = P [log V (T ) < log X | Ft ] = ∞ n=0 ∞ n=0 CHAPTER 13. That means. bankruptcy occurs if the firm value V (t) hits a specified stochastic boundary X(t). . The above structural approach has the additional deficiency that it is usually difficult to determine and trace a firm’s value process. and not just at maturity T . we fix a probability space (Ω. T ]. t ∈ [0.

Let Ft∗ := {A ∈ Ft | ∃B ∈ Gt with property (13. t] × B where s < t and B ∈ Fs . where Ht := σ(H(s) | s ≤ t) and Gt ∨ Ht stands for the smallest σ-algebra containing Gt and Ht . The formal statement is as follows. Proof. By the Doob–Meyer decomposition ([14. The (Ft )-predictable σ-algebra on R+ × Ω is generated by all left-continuous (Ft )adapted processes. T ) = 1{Td ≤t} + E [A(T ) − A(t) | Ft ] .2.2. Let t ∈ R+ . Td is not a stopping time for (Gt ).1)} .4.13. 1 (13.1.1) . INTENSITY BASED METHOD 151 Obviously. Lemma 13. Theorem 1. or equivalently. This formula is the best we can hope for in general. H is a uniformly integrable submartingale. by the sets {0} × B where B ∈ F0 and (s. This nicely reflects the aforementioned difficulties to determine the exact default event in practice. For every A ∈ Ft there exists B ∈ Gt such that A ∩ {Td > t} = B ∩ {Td > t}. In other words. events in Ft are Gt -observable given that Td > t. Intuitively speaking. T ) by making more and more restrictive assumptions (D1)–(D4). (D1) There exists a strict sub-filtration (Gt ) ⊂ (Ft ) (partial market information) and a (Gt )-adapted process Λ such that A(t) = Λ(t ∧ Td ) and Ft = Gt ∨ Ht . We proceed in several steps towards an explicit expression for pd (t.10]) there exists a unique (Ft )-predictable1 increasing process A(t) such that M (t) := H(t) − A(t) is a (uniformly integrable) martingale (notice that A(t) = A(t ∧ Td )). A market participant with access to the partial market information Gt cannot observe whether default has occurred by time t (Td ≤ t) or not (Td > t). Hence pd (t.

Notice that X(t) := P [Td > t | Gt ] is a (Gt )-supermartingale and E[X(t)] is right-continuous in t (→ exercise).4) the rather surprising fact that if Γ is regular enough then it coincides with Λ on [0. Hence X(t). Let t ∈ R+ and Y a random variable.2. Simply take B = A. By Lemma 13.13]. (13. Then E 1{Td >t} Y | Ft = 1{Td >t} eΓ(t) E 1{Td >t} Y | Gt . Hence. Since Ft∗ is a σ-algebra (→ exercise) and Ft is defined to be the smallest σ-algebra containing Gt and Ht .2) Proof. This proves the lemma. by the very definition of the Gt -conditional expectation. Lemma 13. admits a right-continuous modification. and so 1A 1{Td >t} = 1B 1{Td >t} . Indeed. Td ]. we conclude that Ft ⊂ Ft∗ . We show below (Lemma 13. Theorem I.1). so we can take for B either ∅ or Ω. (D2) The default probability by t as seen by a Gt -informed observer satisfies 0 < P [Td ≤ t | Gt ] < 1. see e. for every A ∈ Ht the intersection A ∩ {Td > t} is either ∅ or {Td > t}. A consequence of the next lemma is that for any Ft -measurable random ˜ ˜ variable Y there exists an Gt -measurable random variable Y such that Y = Y on {Td > t}. [14.152 CHAPTER 13.2. DEFAULT RISK Clearly Gt ⊂ Ft∗ . = B = A . Moreover Ht ⊂ Ft∗ .2. and thus Γ(t).1 there exists a B ∈ Gt with (13.3.2. 1{Td >t} Y P [Td > t | Gt ] dP = = B A B 1{Td >t} Y P [Td > t | Gt ] dP E 1{Td >t} Y | Gt P [Td > t | Gt ] dP 1{Td >t} E 1{Td >t} Y | Gt dP 1{Td >t} E 1{Td >t} Y | Gt dP.g. Hence we can define the positive (Gt )-adapted hazard process Γ by e−Γ(t) := P [Td > t | Gt ] . Let A ∈ Ft .

(13.3. Let t ≤ T .3). Equation (13. INTENSITY BASED METHOD This implies E 1{Td >t} Y P [Td > t | Gt ] | Ft = 1{Td >t} E 1{Td >t} Y | Gt . 153 As a consequence of the preceding lemmas we may now formulate the following results. Moreover. the processes L(t) := 1{Td >t} eΓ(t) = (1 − H(t))eΓ(t) is an (Ft )-martingale. which contain an expression for the aforementioned default probabilities. which proves (13. . Then 1{Td >T } = 1{Td >t} 1{Td >T } .4) follows since 1{t<Td ≤T } = 1{Td >t} − 1{Td >T } . Using this and (13. For the second statement it is enough to consider E [L(T ) | Ft ] = E 1{Td >t} 1{Td >T } eΓ(T ) | Ft since by definition of Γ E 1{Td >T } eΓ(T ) | Gt = E E 1{Td >T } | GT eΓ(T ) | Gt = 1. Proof.4) = 1{Td >t} eΓ(t) E E 1{Td >T } | GT | Gt = 1{Td >t} eΓ(t) E e−Γ(T ) | Gt . which proves the lemma.2. Lemma 13.13.2. For any t ≤ T we have P [t < Td ≤ T | Ft ] = 1{Td >t} E 1 − eΓ(t)−Γ(T ) | Gt . = 1{Td >t} eΓ(t) E 1{Td >T } eΓ(T ) | Gt = L(t).2) we derive P [Td > T | Ft ] = E 1{Td >t} 1{Td >T } | Ft = 1{Td >t} eΓ(t) E 1{Td >T } | Gt P [Td > T | Ft ] = 1{Td >t} E eΓ(t)−Γ(T ) | Gt .3) (13.

(Gt )-adapted process λ such that t Γ(t) = 0 λ(s) ds. In view of (13.154 CHAPTER 13. Proof. Hence we refer to λ(t) as default intensity.4. by the uniqueness of the predictable Doob– Meyer decomposition.3) we have t E [N (T ) | Ft ] = 1 − E 1{Td >T } | Ft − T 0 λ(s)1{Td >s} ds − t E λ(s)1{Td >s} | Ft ds T t t λ(u) du = 1 − 1{Td >t} E e− T | Gt − 0 λ(s)1{Td >s} ds − We have further T t 1{Td >t} e t 0 λ(u) du E λ(s)1{Td >s} | Gt ds . . The process t N (t) := H(t) − 0 λ(s)1{Td >s} ds is an (Ft )-martingale.2. Lemma 13. DEFAULT RISK (D3) There exists a positive.4) gives λ(t). we have t Λ(t ∧ Td ) = 0 λ(s)1{Td >s} ds = Γ(t ∧ Td ). Let t ≤ T . Here is the announced result for Γ. Hence. Taking (formally) the right-hand T -derivative at T = t in (13. =:I I= t 1{Td >t} e t t 0 λ(u) du E λ(s)E 1{Td >s} | Gs | Gt ds s t T = 1{Td >t} E λ(s)e− T t λ(u) du ds | Gt = 1{Td >t} E 1 − e− λ(u) du | Gt . measurable.

We can define its right inverse C(s) := inf{t | Γ(t) > s}. Td = inf {t | Γ(t) ≥ φ} . Suppose Γ is continuous. The next and last assumption leads the way to implement a default risk model. Hence Γ(t) is non-decreasing and continuous. Then φ := Γ(Td ) is an exponential random variable with parameter 1 and independent of G∞ . so P [Γ(Td ) > s | G∞ ] = P [Td > C(s) | G∞ ] = e−Γ(C(s)) = e−s .2.13. This proves that φ = Γ(Td ) is an exponential random variable with parameter 1 and independent of G∞ . (D4) P [Td > t | G∞ ] = P [Td > t | Gt ] ∀t ∈ R+ . P [Td > t | G∞ ] = e−Γ(t) . By assumption. Lemma 13. INTENSITY BASED METHOD hence E [N (T ) | Ft ] = 1 − 1{Td >t} − 0 t 155 λ(s)1{Td >s} ds = N (t).2.5. (D2) and (D4). It can be shown that (D4) is equivalent to the hypothesis (H) Every square integrable (Gt )-martingale is an (Ft )-martingale. Then Γ(t) > s ⇔ t > C(s) and Γ(C(s)) = s. Td = inf{t | Γ(t) ≥ Γ(Td )} = inf{t | Γ(t) ≥ φ}. Moreover. . Proof. Chapter 6]. For the next lemma we only assume (D1). For more details we refer to [1. Moreover.

. where Ht = σ(H(s) | s ≤ t).s. Let λ(t) be a positive.1 Construction of Intensity Based Models The construction of a model that satisfies (D1)–(D4) is straightforward. Consequently. We then fix an exponential random variable φ with parameter 1 and independent of G∞ . DEFAULT RISK 13. λ(u) du by the independence of φ and GT (this is a basic lemma for conditional expectations).2. we have for t ≤ T T P [Td > T | Gt ] = P φ > 0 λ(u) du | Gt T 0 =E P φ> = E e− T 0 λ(u) du | GT | Gt | Gt . We start with a filtration (Gt ) satisfying the usual conditions and G∞ = σ(Gt | t ∈ R+ ) ⊂ F . for all t ∈ R+ . measurable.156 CHAPTER 13. and define the random time t Td := inf t | 0 λ(s) ds ≥ φ with values in (0. As for (D4) we notice that t P [Td > t | G∞ ] = P φ > 0 λ(u) du | G∞ = e− t 0 λ(u) du = P [Td > t | Gt ] . We finally define Ft := Gt ∨ Ht . Conditions (D1)–(D3) are obviously satisfied for t Λ(t) = Γ(t) := 0 λ(s) ds. (Gt )-adapted process with the property t 0 λ(s) ds < ∞ a. ∞]. And it is an easy exercise to show that 0 < P [Td > t | Gt ] = e− t 0 λ(u) du Td < 1 and φ = 0 λ(u) du.

(13. Moreover. (γ − β) (eγu − 1) + 2γ γ := β 2 + 2σ 2 .3) we need a tractable model for the intensity process λ. b ≥ 0. if Td > t else. In addition. Notice that λ ≥ 0 is essential. we suppose now that we are given a risk-neutral probability measure Q ∼ P and a measurable. INTENSITY BASED METHOD 157 13. 13. . we assume that there exists a positive. for all t ∈ R+ .13. So let W be a (Gt )-Brownian motion. ΛQ := ΓQ and ΓQ replacing P.5) the conditional default probability is pd (t. measurable. and (D1)–(D3) are satisfied for Q.6.2. 1 − e−A(T −t)−B(T −t)λ(t) .2. these conditions are not preserved under an . respectively (unfortunately. 0. λ(0) ≥ 0. Λ and Γ.s. Lemma 13. T ) = P [Td ≤ T | Ft ] = where 2γe(γ−β)u/2 2b A(u) := − 2 log σ (γ − β) (eγu − 1) + 2γ 2 (eγu − 1) B(u) := . and let dλ(t) = (b + βλ(t)) dt + σ λ(t) dW (t). For the intensity process (13.2 Computation of Default Probabilities When it comes to computations of the default probabilities (13. But the right-hand side of (13. An obvious and popular choice for λ is thus a square root (or affine) process.2. β ∈ R and σ > 0 some constants.3) looks just like what we had for the risk-neutral valuation of zero-coupon bonds in terms of a given short rate process (Chapter 7). (Gt )adapted short rate process r(t).2. (Gt )-adapted process λQ such that t ΓQ (t) := 0 λQ (s) ds < ∞ a.5) The proof of the following lemma is left as an exercise.3 Pricing Default Risk The stochastic setup is as above.

158 CHAPTER 13. (13.7) For the intensity process we chose the affine combination λQ (t) = c0 + c1 r(t).8) . (13. for two constants c0 . r(0) ≥ 0. T ) is C(t. b ≥ 0. c1 ≥ 0. For the short rates we chose CIR: let W be a (Q. A tractable (hence affine) model is easily found. DEFAULT RISK equivalent change of measure in general).2.2 this is C(t. Gt )-Brownian motion. As for the recovery we fix a constant recovery rate δ ∈ (0. β ∈ R.2. • Partial recovery at maturity: the cashflow at T is 1{Td >T } + δ1{Td ≤T } . r(s) ds 1{Td >T } | Ft . • Partial recovery at default: the cashflow is Zero-Recovery The arbitrage price of C(t.2.6) λQ (s) ds λQ (s) ds EQ e − EQ e − T t T t r(s) ds r(s) ds = 1{Td >t} EQ e− T t (r(s)+λQ (s))ds | Gt . We will determine the price C(t.1–13.4 apply. δ at Td if Td ≤ T . T ) = EQ e− In view of Lemma 13. Pricing a corporate bond boils down to the pricing of a non-defaultable zero-coupon bond with the short rate process replaced by r(s) + λQ (s) ≥ r(s). 1) and distinguish three cases: • Zero recovery: the cashflow at T is 1{Td >T } . which may default. T ) of a corporate zero-coupon bond with maturity T . So that Lemmas 13. T ) = 1{Td >t} e = 1{Td >t} e t 0 t 0 T t 1 at T if Td > T . 1{Td >T } | Gt EQ 1{Td >T } | GT | Gt (13. Notice that this is a very nice formula. σ > 0 constant parameters and dr(t) = (b + βr(t)) dt + σ r(t) dW (t).

Here we have C(t. T ) stands for the price of the default-free zero-coupon bond.1 and 13.2. where 2γe(γ−β)u/2 2b(1 + c1 ) log A(u) := c0 u − σ2 (γ − β) (eγu − 1) + 2γ 2 (eγu − 1) (1 + c1 ).6) hence C(t. Partial Recovery at Maturity This is an easy modification of the preceding case since 1{Td >T } + δ1{Td ≤T } = (1 − δ) 1{Td >T } + δ. T ). T ) = 1{Td >t} e−A(T −t)−B(T −t)r(t) . B(u) := (γ − β) (eγu − 1) + 2γ γ := β 2 + 2(1 + c1 )σ 2 . Exercise.2. where P (t. where P (t. T ) = 1{Td >t} e−c0 (T −t) P (t.2 shows that EQ 1{Td >t} Y | G∞ ∨ Ht = 1{Td >t} e t 0 λQ (s) ds EQ 1{Td >t} Y | G∞ .2. T ).13. T ) is the CIR price of a default-free zero-coupon bond.7. For the above affine model we have C(t. In view of (13. INTENSITY BASED METHOD Lemma 13.2. Proof. T ) = (1 − δ) 1{Td >t} EQ e− T t (r(s)+λQ (s))ds 159 . | Gt + δP (t. A special case is c1 = 0 (constant intensity). Partial Recovery at Default A straightforward modification of the proofs of Lemmas 13.

1 we obtain for t ≤ u Q[t < Td ≤ u | G∞ ∨ Ht ] = 1{Td >t} e = 1{Td >t} e t 0 t 0 λQ (s) ds λQ (s) ds EQ 1{t<Td ≤u} | G∞ e− t 0 λQ (s) ds − e− u 0 λQ (s) ds = 1{Td >t} 1 − e− u t λQ (s) ds . Combining this with Section 13. For the above affine model (13. T ) is the bond price with zero recovery. where C0 (t. 13.2. T ) + π(t).2. As a result.4 Measure Change We consider an equivalent change of measure and derive the behavior of the compensator process for the stopping time Td . Again. T ) = C0 (t. Differentiation in with respect to u yields its density function 1{Td >t} λQ (u)e− u t λQ (s) ds 1{t≤u} .160 CHAPTER 13. which is the regular conditional distribution of Td conditional on {Td > t} and G∞ ∨ Ht .7)–(13.8) this expression can be made more explicit (→ exercise). the price of the corporate bond bond price with recovery at default is C(t. DEFAULT RISK for every random variable Y . The above calculations and an extension to stochastic recovery go back to Lando [16]. we take the above . Hence the arbitrage price of the recovery at default given that t < Td ≤ T is given by π(t) = EQ e− Td t r(s) ds Td t δ1{t<Td ≤T } | Ft δ1{t<Td ≤T } | G∞ ∨ Ht | Ft u t = E Q EQ e − = δ1{Td >t} EQ T r(s) ds T e− t r(s) ds λQ (u)e− u t λQ (s) ds du | Ft = δ1{Td >t} t EQ λQ (u)e− u (r(s)+λQ (s)) ds t | Ft du.

Lemma 13. The following analysis involves stochastic calculus for cadlag processes of finite variation (FV). We recall the integration by parts formula for two right-continuous FV functions f and g t t f (t)g(t) = f (0)g(0) + 0 f (s−) dg(s) + 0 g(s−) df (s) + [f. We will construct an equivalent probability measure Q ∼ P such that ΛQ (t ∧ Td ) is the (Q. t < Td µ(Td ). imply that ΛQ (t) is the (Q. see also [1. Section 7. Gt )-hazard process ΓQ (t) = − log Q[Td > t | Gt ] of Td in general.s. Ft )-martingale. however.2. ∆f (s) := f (s) − f (s−). g](t) = 0<s≤t ∆f (s)∆g(s). The process D(t) := C(t)V (t) with t C(t) := exp 0 (1 − µ(s))λ(s)1{Td >s} ds 1.2. A counterexample has been constructed by Kusuoka [15].13. where [f. INTENSITY BASED METHOD stochastic setup and let (D1)–(D3) hold.3]. This does not. t ≥ Td V (t) := 1{Td >t} + µ(Td )1{Td ≤t} = . g](t). So that t 161 M (t) = H(t) − 0 λ(s)1{Td >s} ds is a (P.8. for all t ∈ R+ . Ft )-compensator of H. which in a sense is simpler than for Brownian motion since it is a pathwise calculus. Now let µ be a positive (Gt )-predictable process such that t ΛQ (t) := 0 µ(s)λ(s) ds < ∞ a.

Since D(s−) is locally bounded and ΛQ (t) < ∞ we conclude that D is a P-local martingale. Lemma 13. dP Then the process MQ (t) := H(t) − ΛQ (t ∧ Td ). Indeed. Theorem 1. DEFAULT RISK t D(s−) (µ(s) − 1) dM (s) and is thus a positive P-local martingale. so that we can define an equivalent probability measure Q ∼ P on FT by dQ = D(T ). V ] = 0 and t t V (t) = 1 + 0 (µ(s) − 1) dH(s) = 1 + 0 V (s−) (µ(s) − 1) dH(s). Let T ∈ R+ .9. t ∈ [0. T ]. Notice that [C.9) therefore the unique Doob–Meyer decomposition of H under Q. Proof.4.162 satisfies D(t) = 1 + 0 CHAPTER 13. so is MQ ([14.2. Hence t t D(t) = 1 + 0 t C(s−) dV (s) + 0 V (s−) dC(s) =1+ 0 t C(s−)V (s−) (µ(s) − 1) dH(s) + 0 C(s)V (s−)(1 − µ(s))λ(s)1{Td >s} ds t 0 =1+ D(s−) (µ(s) − 1) dM (s). (13. is a Q-martingale.9) .10]). Suppose E[D(T )] = 1 (hence (D(t))t∈[0. ΛQ is an increasing continuous (and hence predictable) process. It is enough to show that MQ is a Q-local martingale.T ] is a martingale). (13. Since H is uniformly integrable. Proof.

2. MQ ](t) = ∆D(Td )1{Td ≥t} = D(Td −) (µ(Td ) − 1) 1{Td ≥t} t = 0 D(s−) (µ(s) − 1) dH(s).3 under Assumption (D4) for Q.3]. Integration by parts gives t t DMQ (t) = = 0 t 0 D(s−) dMQ (s) + D(s−) dH(s) − t 0 t 0 t 0 MQ (s−) dD(s) + [D.3 do not apply for the above situation. .2. there is a way to derive the pricing formulas from Section 13. Section 8. Yet. MQ ](t) D(s−)µ(s)λ(s)1{Td >s} ds t 0 t + = 0 MQ (s−) dD(s) + D(s−) (µ(s) − 1) dH(s) MQ (s−) dD(s) + D(s−)µ(s) dM (s). Pricing by the “Martingale Approach” We remark again that ΛQ is different from ΓQ in general. 0 which proves the claim.2. so that the methods from Section 13. Notice that [D.13. INTENSITY BASED METHOD 163 From Bayes’ rule we know that MQ is a Q-local martingale if and only if DMQ is a P-local martingale. The detailed analysis can be found in [1.

164 CHAPTER 13. DEFAULT RISK .

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