J Syst Sci Complex (2010) 23: 484–498

INTEREST RATE RISK PREMIUM AND EQUITY

VALUATION∗
Zhuang KANG · Srdjan D. STOJANOVIC

DOI: 10.1007/s11424-010-0142-y
Received: 3 December 2009 / Revised: 4 February 2010
The
c Editorial Office of JSSC & Springer-Verlag Berlin Heidelberg 2010

Abstract The authors employ the recent stochastic-control-based approach to financial mathematics
to solve a problem of determination of the risk premium for a stochastic interest rate model, and
the corresponding problem of equity valuation. The risk premium is determined explicitly, by means
of solving a corresponding partial differential equation (PDE), in two forms: one, time-dependent,
corresponding to a finite time contract expiration, and the simpler version corresponding to perpetual
contracts. As stocks are perpetual contracts, when solving the problem of equity valuation, the latter
form of the risk premium is used. By means of solving the general pricing PDE, an efficient equity
valuation method was developed that is a combination of some sophisticated explicit formulas, and a
numerical procedure.
Key words Equity valuation, incomplete markets, interest rate risk, neutral pricing, risk premium.

1 Introduction
In recent years significant advances were made in mathematical solutions to problems of
determination of risk premium for pricing of financial instruments, as well as in introducing the
financial mathematics, i.e., financial engineering framework into the so-called financial “funda-
mental analysis”, or equity valuation.
The determination of risk premium was a missing link for many years in the pricing theory
for incomplete markets (markets in which not all the risks are hedgeable). What was usually
done is that the risk premium was not determined as a consequence of the assumed market
model, but rather just postulated in some simple mathematical form, and then estimated sta-
tistically. On the other hand, in recent works, such as [1–2], the deep connection between
portfolio optimization and pricing was exploited, with the help of partial differential equations
(PDE) methods, to derive mathematically the risk premium corresponding to postulated market
models.
The general paradigm for the, so called, neutral pricing, which is suitable for pricing of
liquid financial contracts, is, for the given market model, to solve first the risk premium PDE,
and then to solve the pricing PDE. Ideally, both PDEs are solved explicitly, as such solutions
are easiest to analyze and implement in financial applications. If that is not possible, then
Zhuang KANG · Srdjan D. STOJANOVIC
Department of Mathematical Sciences, University of Cincinnati, Cincinnati OH 45221-0025, USA.
∗ This research was supported in part by the Center for Financial Engineering at the Suzhou University, China,

and the Taft Research Center at the University of Cincinnati, USA.

 INTEREST RATE RISK PREMIUM AND EQUITY VALUATION 485

solving the risk premium explicitly, while having the pricing PDE solved in a somewhat less
convenient form is also quite useful.
In this paper we present that kind of a solution. We first derive formulas for the interest
rate risk premium when short rate follows a new variant of the well known Vasicek model, and
then employ this result in the problem of pricing equity (“fundamental analysis” for pricing
stocks) under the assumption of stochastic interest rates.
The equity valuation part of this paper is based on recent results on pricing equity[1−3] , but is
more challenging than the “basic equity model” of [3], and therefore yields a “partially explicit-
partially numerical” valuation method. Our pricing method, i.e., the pricing PDE solution
method, is based on the method that was elaborated by Harper in [4]. It is also supplemented
by a numerical solution, for the part of the solution.

2 A Variant of the Vasicek Model for Stochastic Interest Rates:

Determination of Risk Premium
2.1 The General Pricing and Hedging Methodology
Recalling from [1, 5–6], an economy E is a finite set of:
1) a cash, or money market account accruing interest at (possibly stochastic) short (interest)
rate r(t),
2) factors, and
3) tradables.
Factors and tradables are denoted by A(t) = {A1 (t), A2 (t), · · · , Am (t)} and S(t) = {S1 (t),
S2 (t), · · · , Sk (t)}, respectively, with typically nonempty intersection, and obeying Itô SDE dy-
namics
dA(t) = b(t, A(t))dt + c(t, A(t)).dB(t),
(1)
dS(t) = S(t) (as (t, A(t)) − D(t, A(t))) dt + S(t)σs (t, A(t)).dB(t),

where B(t) = {B1 (t), B2 (t), · · · , Bn (t)} is a standard n-dimensional Brownian motion, b(t, A)
is the m-vector of factor-drifts, c(t, A) is m × n factor-diffusion-matrix, as (t, A) is the k-vector
of (pre-dividend) appreciation rates for the tradables, D(t, A) is the k-vector of dividend rates,
σs (t, A) is the volatility k × n-matrix. Functions as , σs , b, c are called market coefficients. Mul-
tiplication “.” is the usual matrix-vector or “dot” multiplication; multiplication “ ” is meant
component-wise.
Consider a portfolio European contracts in the economy E, expiring at time T ≤ ∞,
with the terminal payoff equal to υ(A(T )) = {υ1 (A(T )), υ2 (A(T )), · · · , υl (A(T ))}, and/or with
dividend payoffs of D(A(t)) = {D1 (A(t)), D2 (A(t)), · · · , Dl (A(t))} (per year) for t < T . The
pricing problem is to find the vector of “fair” prices V (t) = {V1 (t), V2 (t), · · · , Vl (t)}, for t < T .
Theorem 1 (See [1] for multiple contracts,and [5] for a single contract) Under the HARA
(i.e., CRRA) utility of wealth ψγ (X) = X 1−γ (1 − γ) (with the relative risk aversion γ; X is
the wealth), the generalized Black−Scholes type system reads as

∂V 1      
+ tr ∇∇V.c.cT + ∇V. b − (as − r) . σs .σs T −1 .σs .cT
∂t 2
   
+∇V.c. I − σs T . σs .σs T −1 .σs .cT .∇gγ − rV

= −(1 − T )D (2)
486 ZHUANG KANG · SRDJAN D. STOJANOVIC

for t < T ≤ ∞, with the terminal condition (if T = ∞, no terminal condition is necessary)

V (T, A) = υ(A), (3)

where gγ is characterized as a (scalar) solution of the “risk premium PDE”

 
∂gγ 1   γ−1  
+ tr c · cT · ∇∇gγ + b − (as − r) · σs · σs T −1 · σs · cT · ∇gγ
∂t 2 γ
 
1 γ−1 T  
T −1
+ ∇gγ · c · I − σs · σs · σs · σs · cT · ∇gγ
2 γ
 
γ−1 1  
= (as − r) · σs · σs T −1 · (as − r) + rγ (4)
γ 2

for t < T < ∞, with the terminal condition

gγ (T, A) = 0. (5)

Moreover, the most conservative hedging formula for κ = {κ1 , κ2 , · · · , κl } contracts with prices
V = {V1 , V2 , · · · , Vl } is given by
   
Π h∞ (t, A) = − σs .σs T −1 .σs .cT .(∇V )T .κ = −κ.∇V.c.σs T . σs .σs T −1 . (6)

Above gradient ∇ denotes the gradient with respect to the factors: ∇ = ∇A . Also, ∇∇gγ
is the Hessian matrix for gγ , while tr denotes the trace of a square matrix On the other hand,
∇∇V = ∇∇ {V1 , V2 , · · · , Vl } is the vector of Hessian matrices (rank-3 tensor), while tr is the
corresponding vector of traces tr (see [1–3, 5] for more details). Notice also that the general
pricing system (2)–(5) is uncoupled: one first solves the risk premium PDE (4)–(5), finding gγ ,
and then, using ∇gγ , one solves (2)–(3).
If, as in our problem, T = ∞, (4)–(5) is solved for T < ∞, and then lim ∇gγ is evaluated
T →∞
(while lim gγ generally does not exist). On the other hand, (2)–(5) is solved directly for
T →∞
T = ∞ as an entire solution (see [6] for details).

2.2 Risk Premium for the Vasicek Model

Consider an economy with only one tradable with price S(t) at time t (e.g., S&P 500 index,
or it’s tradable equivalent), assumed to obey a stochastic differential equation (SDE):

dS(t) = S(t) (a0 + βr(t) − Ds ) dt + S(t)vdB1 (t), (7)

with the (pre-dividend) appreciation rate a(t) = a0 + βr(t), where a0 and β are given (i.e.,
statistically estimated) constants, and r(t) is the stochastic interest rate, also called short rate.
Also in (7), Ds is a given dividend rate, while v is the volatility. A special case when β = 1 was
solved previously by one of the authors in [6].
Consider stochastic interest rate r(t), and assume that it obeys a Vasicek type model[2,7−9] :
 
dr(t) = (μr,0 + μr,1 r(t)) dt + wr ρ2,1 dB1 (t) + 1 − ρ22,1 dB2 (t) , (8)

where ρ2,1 is the instantaneous correlation between the tradable S(t) and the interest rate r(t)
(B1 (t) and B2 (t) are two independent standard Brownian motions); also model coefficients μr,0 ,
μr,1 and wr are given (estimated) constants.
 INTEREST RATE RISK PREMIUM AND EQUITY VALUATION 487

The interest rate SDE (8) without SDE (7), is known as the Vasicek short rate model:
Assuming μr,1 < 0, the interest rate is mean-reverting around its long term average −μr,0 /μr,1 ,
and diffusing with intensity wr . Notice that such a model allows the interest rate to become
negative.
Following the general paradigm for determination of the pricing risk premium, we attempt
to solve PDE (2)–(3), which by means of market coefficients,
 
as = {a0 + βr} , σs = v 0 ,


Sv  0 (9)
b = {S (a0 + βr − Ds ) , μr,0 + μr,1 r} , c = 2 .
wr ρ2,1 wr 1 − ρ2,1

becomes (throughout, the partial derivatives are also denoted as, for example, gγ (0,0,1) (t, S, r) =
∂gγ (t, S, r)/ ∂r),
 (γ − 1)wr (βr − r + a0 ) ρ2,1 (0,0,1)
μr,0 + rμr,1 − gγ (t, S, r)
vγ
 
S(γ − 1) (βr − r + a0 )
+ S (−Ds + rβ + a0 ) − gγ (0,1,0) (t, S, r)
γ
  
1 γ−1 
+ vS 1 − gγ (0,1,0) (t, S, r) wr ρ2,1 gγ (0,0,1) (t, S, r)
2 γ
  
+vSgγ (0,1,0) (t, S, r) + gγ (0,0,1) (t, S, r) 1 − ρ22,1 gγ (0,0,1) (t, S, r)wr2
   
γ−1 (0,0,1) (0,1,0)
+ 1− ρ2,1 wr ρ2,1 gγ (t, S, r) + vSgγ (t, S, r) wr
γ
1
+ v 2 gγ (0,2,0) (t, S, r)S 2 + 2vwr ρ2,1 gγ (0,1,1) (t, S, r)S
2

+wr 2 gγ (0,0,2) (t, S, r) + gγ (1,0,0) (t, S, r)
 
γ−1 (βr − r + a0 ) 2
= + rγ , (10)
γ 2v 2
gγ (T, S, r) = 0. (11)
Looking for the solution in the form gγ (t, S, r) = gγ (t, r), the above PDE reduces to
 
(γ − 1)wr (βr − r + a0 ) ρ2,1
μr,0 + rμr,1 − gγ (0,1) (t, r)
vγ

  
1 γ−1 2 (0,1) 2
 2
 (0,1) 2
+ 1− ρ2,1 gγ (t, r)wr + 1 − ρ2,1 gγ (t, r)wr
2 γ
1
gγ (0,1) (t, r) + wr 2 gγ (0,2) (t, r) + gγ (1,0) (t, r)
2
 
γ − 1 (βr − r + a0 ) 2
= + rγ , (12)
γ 2v 2

gγ (T, r) = 0, (13)
488 ZHUANG KANG · SRDJAN D. STOJANOVIC

We look for the solution in the form gγ (t, r) = G2 (t)r2 + G1 (t)r + G0 (t), obtaining

G2 (t)r2 + G1 (t)r + wr 2 G2 (t)

 
(γ − 1)wr (βr − r + a0 ) ρ2,1  
+ μr,0 + rμr,1 − G1 (t) + 2rG2 (t)
vγ

 
1  γ−1  
+ G1 (t) + 2rG2 (t) 1− ρ22,1 G1 (t) + 2rG2 (t) wr2
2 γ

   
+ 1 − ρ22,1 G1 (t) + 2rG2 (t) wr2 + G0 (t)
 
γ−1 (βr − r + a0 ) 2
= + rγ , (14)
γ 2v 2

G0 (T ) = G1 (T ) = G2 (T ) = 0. (15)
For any r ∈ (−∞, ∞), therefore arriving at 3 ODEs characterizing G0 , G1 , G2 . As ∇gγ is only
needed for pricing (see (2)), and as

∂gγ ∂gγ
∇gγ = , = {0, G1 (t) + 2rG2 (t)} ,
∂S ∂r

only G1 , G2 are needed. As, furthermore, they are characterized independently of G0 , we need
only 2 ODEs:
(1 − γ)β 2 2(γ − 1)wr ρ2,1 G2 (t)β (1 − γ)β
− −
2v 2 γ vγ v2 γ
 
γ−1  
+2 1 − wr2 ρ22,1 G2 (t)2 + 2wr2 1 − ρ22,1 G2 (t)2
γ
2(γ − 1)wr ρ2,1 G2 (t) 1−γ
+2μr,1 G2 (t) + + G2 (t) + 2
vγ 2v γ
= 0, (16)
G2 (T ) = 0, (17)
 γ − 1 2  
2 1− ρ2,1 G1 (t)G2 (t)wr2 + 2 1 − ρ22,1 G1 (t)G2 (t)wr2
γ
(γ − 1)ρ2,1 G1 (t)wr β(γ − 1)ρ2,1 G1 (t)wr
+ −
vγ vγ
2(γ − 1)a0 ρ2,1 G2 (t)wr β(1 − γ)a0
− −γ + + μr,1 G1 (t)
vγ v2 γ
(1 − γ)a0
+2μr,0 G2 (t) + G1 (t) − +1
v2 γ
= 0, (18)
G1 (T ) = 0, (19)
 INTEREST RATE RISK PREMIUM AND EQUITY VALUATION 489

These ODEs are solved as:

1
G2 (t) =  vγμr,1 + wr (γ − 1)ρ2,1
2vwr 2 γ (ρ2,1 2 − 1) − ρ2,1 2

− γ (−(γ − 1)wr 2 − 2v(γ − 1)μr,1 ρ2,1 wr − v 2 γμr,1 2 )

  
(t − T ) (γ − 1)wr 2 + 2v(γ − 1)μr,1 ρ2,1 wr + v 2 γμr,1 2
tan 
v γ (−(γ − 1)wr 2 − 2v(γ − 1)μr,1 ρ2,1 wr − v 2 γμr,1 2 )
 
−1 vγμr,1 + wr (γ − 1)ρ2,1
+ tan  , (20)
γ (−(γ − 1)wr 2 − 2v(γ − 1)μr,1 ρ2,1 wr − v 2 γμr,1 2 )
and

  t
G1 (t) = exp −v 2 γμr,1 + vwr ρ2,1 − vwr γρ2,1 − 2v 2 wr 2 γG2 (ξ)
1
  
−2v 2 wr 2 ρ2,1 2 G2 (ξ) + 2v 2 wr 2 γρ2,1 2 G2 (ξ) / v 2 γ dξ
 t
1   τ
· 2
exp − −v 2 γμr,1 + vwr ρ2,1 − vwr γρ2,1
1 v γ 1
  
−2v wr γG2 (ξ) − 2v 2 wr 2 ρ2,1 2 G2 (ξ) + 2v 2 wr 2 γρ2,1 2 G2 (ξ) / v 2 γ dξ
2 2

 
a − v 2 γ − aγ + v 2 γ 2 − 2v 2 γμr,0 G2 (τ ) − 2vwr aρ2,1 G2 (τ ) + 2vwr aγρ2,1 G2 (τ ) dτ
 T   τ
1
− 2
exp − −v 2 γμr,1 + vwr ρ2,1 − vwr γρ2,1
1 v γ 1
  
−2v wr γG2 (τ ) − 2v 2 wr 2 ρ2,1 2 G2 (ξ) + 2v 2 wr 2 γρ2,1 2 G2 (τ ) / v 2 γ dξ
2 2


· a − v 2 γ − aγ + v 2 γ 2 − 2v 2 γμr,0 G2 (τ ) − 2vwr aρ2,1 G2 (τ ) + 2vwr aγρ2,1 G2 (τ ) dτ .
(21)
We notice that a special case β = 1, solved in [6], is much easier, as in such a case the first
ODE reduces to:
 
γ−1  
2 1− wr2 ρ22,1 G2 (t)2 + 2wr2 1 − ρ22,1 G2 (t)2 + 2μr,1 G2 (t) + G2 (t) = 0,
γ
G2 (T ) = 0,
which is solved by G2 (t) = 0, and then the second ODE reduces to
G1 (t) + μr,1 G1 (t) = γ − 1,
G1 (T ) = 0,
which is solved by  
1 − e(T −t)μr,1 (γ − 1)
G1 (t) = ,
μr,1
490 ZHUANG KANG · SRDJAN D. STOJANOVIC

Notice also that in the case β = 1, if, as assumed, μr,1 < 0, then lim ∇gγ = lim ∇gγ =
  T →∞ t→−∞
γ−1
lim {0, G1 (t)} = 0, μr,1 — “the perpetual risk premium”. We now determine lim ∇gγ
t→−∞ t→−∞
in the case β = 1.
First differentiate (12) with respect to r, obtaining
 
wr (β − 1)(γ − 1)ρ2,1 (0,1)
μr,1 − g (t, r)
vγ
 
wr (γ − 1) (βr − r + a0 ) ρ2,1 (0,2)
+ μr,0 + rμr,1 − g (t, r)
vγ

  
1 γ−1 2 (0,1) 2
 2
 (0,1)
+ 1− ρ2,1 g (t, r)wr + 1 − ρ2,1 g (t, r)wr g (0,2) (t, r)
2
2 γ

  
1 (0,1) γ−1 2 (0,2) 2
 2
 (0,2) 2
+ g (t, r) 1− ρ2,1 g (t, r)wr + 1 − ρ2,1 g (t, r)wr
2 γ
1
+ wr 2 g (0,3) (t, r) + g (1,1) (t, r)
2
 
(γ − 1) (β − 1) (βr − r + a0 )
= γ+ . (22)
γ v2
The goal is to derive an equation for lim g (0,1) (t, r). Therefore, we make a substitution
t→−∞

g(t, r) → h(r) dr

obtaining
 
(β − 1)(γ − 1)wr ρ2,1
μr,1 − h(r)
vγ
 
(γ − 1)wr (βr − r + a0 ) ρ2,1 
+ μr,0 + rμr,1 − h (r)
vγ
  
1 γ−1   2
+ 1− h(r)ρ2,1 wr + h(r) 1 − ρ2,1 wr h (r)
2 2 2
2 γ

  
1 γ −1    1
+ h(r) 1− ρ2,1 h (r)wr + 1 − ρ2,1 h (r)wr + wr 2 h (r)
2  2 2 2
2 γ 2
 
(γ − 1) (β − 1) (βr − r + a0 )
= γ+ (23)
γ v2

for −∞ < r < ∞. We are looking for the “entire solution” (23) in the form h(r) = H0 + H1 r,
therefore obtaining
 
(−1 + β)(−1 + γ)wr ρ2,1
(H0 + rH1 ) μr,1 −
vγ
 
(−1 + γ)wr (−r + rβ + a0 ) ρ2,1
+H1 μr,0 + rμr,1 −
vγ
 INTEREST RATE RISK PREMIUM AND EQUITY VALUATION 491

  
1 −1 + γ 2 2 2
 2

+ (H0 + rH1 ) 1− wr H1 ρ2,1 + wr H1 1 − ρ2,1
2 γ

  
1 −1 + γ 2 2 2
 2

+ H1 1− wr (H0 + rH1 ) ρ2,1 + wr (H0 + rH1 ) 1 − ρ2,1
2 γ
 
γ−1 (β − 1) (r(β − 1) + a0 )
= γ+
γ v2
for −∞ < r < ∞. Therefore, we arrive at algebraic equations

(γ − 1)wr H1 ρ2,1 (β − 1)(γ − 1)wr H1 ρ2,1

2H1 μr,1 + −
vγ vγ
 
β(γ − 1)wr H1 ρ2,1 γ−1  
− + 1− wr2 H21 ρ22,1 + wr2 H21 1 − ρ22,1
vγ γ
(β − 1)2 (γ − 1)
= , (24)
v2 γ

(β − 1)(γ − 1)wr H0 ρ2,1 (γ − 1)wr a0 H1 ρ2,1

H1 μr,0 + H0 μr,1 − −
vγ vγ
 
γ−1  
+ 1− wr2 H0 H1 ρ22,1 + wr2 H0 H1 1 − ρ22,1
γ
(β − 1)(γ − 1)a0
= γ−1+ , (25)
v2 γ
characterizing H0 and H1 , and therefore also characterizing the “perpetual risk premium”:
lim ∇gγ = lim {0, G1 (t) + 2rG2 (t)} = {0, H0 + H1 r}. Again, if β = 1, Equation (24) is
t→−∞ t→−∞
solved by H1 = 0, and then Equation (25) becomes H0 = γ−1 μr,1 , which is consistent with the
result in [6]. Also notice, if γ = 1, for any β, H0 = H1 = 0.
Theorem 2 Under the stochastic interest rate model above,

∂gγ ∂gγ
∇gγ = , = {0, G1 (t) + 2rG2 (t)} , (26)
∂S ∂r

where G1 (t) and G2 (t) are characterized as solutions of ODEs (16)–(19), and given by (20) and
(21). Moreover
lim ∇gγ = {0, H0 + H1 r} , (27)
t→−∞

where H0 and H1 are characterized as solutions of algebraic equations (24)–(25).

3 Basic Equity Model Under Stochastic Interest Rates

3.1 Problem Set-Up
A general, incomplete-market derivative-based equity-pricing framework was developed by
one of the authors in [1, 3, 6]. For completeness, we recall some of the results: Consider a
publicly traded company with the net income rate, denoted by i(t), obeying the stochastic
492 ZHUANG KANG · SRDJAN D. STOJANOVIC

differential equation (SDE):


di(t) = μi,0 + μi,1 i(t) dt
  ρ3,2 − ρ2,1 ρ3,1

+ wi,0 + wi,1 i(t) ρ3,1 dB1 (t) +  dB2 (t) + P3 dB3 (t) , (28)
1 − ρ2,1 2

1+2ρ2,1 ρ3,1 ρ3,2 −(ρ2,1 2 +ρ3,1 2 +ρ3,2 2 )
where P3 = 1−ρ2,1 2 .
In addition to the net income rate, consider also the available cash (and its equivalents) and
assume the following dynamics

dC(t) = (i(t) + C(t) (r(t) − p1 ) − (α0 + α1 i(t) + α3 C(t))) dt, (29)

where, p1 is a given company surcharge rate: C(t)p1 dt is the cost to the company during the time
interval dt that is related (proportional) to the available cash C(t) (see [3] for more details). Of
course, i(t)dt is the net income (or loss, if negative) during the time interval dt, while C(t)r(t)dt
is the interest earned in the money market (if C(t) > 0). Also, the last cash flow in (29) is
the dividend policy: D = α0 + α1 i + α3 C, where, α0 , α1 and α3 are given constants (α2 is
missing just for the sake of consistence of notation with [3], where a separate basic cost rate
is considered as well; the solution method below depends on having only one stochastic cash
flow, which is the reason that here we combine income and basic cost into a net income), so
that D(t)dt is the amount of money paid as a dividend during the time interval dt. Finally, let
also T denote the dividend tax rate.
The problem is to price the stock of the company using the above recalled general pricing
methodology. To that end, i.e., to realize system (1), consider some tradable S = {S}, obeying
(7), and a four-dimensional factor A = {S, r, i, C}, with the corresponding market coefficients:

 
as ={a + βr}, σs = v 0 0 ,
 
b = S (a0 + βr − Ds ) , μr,0 + μr,1 r, μi,0 + μi,1 i, i + C (r − p1 ) − (α0 + α1 i + α3 C) ,

⎛ ⎞ (30)
Sv 0 0
⎜ ⎟
⎜ wr ρ2,1 wr 1 − ρ22,1 0 ⎟
c =⎜
⎜ (w + iw ) ρ
⎟.
(wi,0 + iwi,1 ) P3 ⎟
(ρ3,2 −ρ2,1 ρ3,1 )
⎝ i,0 i,1 3,1 (wi,0 + iwi,1 ) √ 2 ⎠
1−ρ2,1
0 0 0

3.2 Risk Premium

Although the risk premium determination for this problem may seem different from the
one considered in Section 2, it is a matter of calculation to see that the risk premium PDE
for this problem reduces to (12), and therefore all what was derived in Section 2 applies in
the current situation as well. So, we shall assume that the problem of finding lim ∇gγ =
t→−∞
{0, H0 + H1 r, 0, 0} is solved already.
 INTEREST RATE RISK PREMIUM AND EQUITY VALUATION 493

3.3 Solving the Pricing PDE

We attempt to find the solution V (t, S, r, i, C) of the pricing PDE (2) on the domain −∞ <
t < T , 0 < S < ∞, −∞ < i < ∞, −∞ < r < ∞ and −∞ < C < ∞. The terminal condition
for V (3) was specified at T ∈ R with an arbitrary value:

(T − 1)α3
V (T, S, r, i, C) = υ(A) = − C. (31)
p1 + α3

We claim that the terminal condition υ(A) is irrelevant for the result because terminal time
T will be sent to ∞ at the end of this work. We are only interested in the steady solution when
t is far away from T (for example, we seek for solution at t = 0 while sending terminal time
T → ∞). Moreover, we are looking for a solution in a linear form:

V (t, S, r, i, C) = A0 (t, r) + Ai (t, r)i + AC (t, r)C (32)

with corresponding terminal conditions:

A0 (T, r) = 0,

Ai (T, r) = 0,
(T − 1)α3
AC (T, r) = − .
p1 + α3
By such assumption, we arrive at the following equation:
 
− (H0 + H1 r) ρ2,1 2 − 1 A0 (0,1) (t, r) + iAi (0,1) (t, r) wr 2

+ (H0 + H1 r) (wi,0 + wi,1 i) (ρ3,2 − ρ2,1 ρ3,1 ) Ai (t, r)wr

1    
+ 2 wi,0 + wi,1 i ρ3,2 Ai (0,1) (t, r) + wr A0 (0,2) (t, r) + iAi (0,2) (t, r) wr
2
 
−AC (t, r) p1 C − rC + α3 C − i + α0 + iα1
   
(r − a) wi,0 + wi,1 i ρ3,1
+ μi,0 + iμi,1 + Ai (t, r)
v
 
  wr (r − a)ρ2,1
−r AC (t, r)C + A0 (t, r) + iAi (t, r) + μr,0 + rμr,1 +
v

A0 (0,1) (t, r) + iAi (0,1) (t, r) + A0 (1,0) (t, r) + iAi (1,0) (t, r)

= −(1 − T ) (α0 + iα1 + Cα3 ) . (33)

which holds for any −∞ < t < T , −∞ < r < ∞, −∞ < i < ∞, and −∞ < C < ∞. By
considering coefficients of C, i, we conclude the following three equations:

−AC (t, r) (p1 + α3 ) = (T − 1)α3 (34)

yielding
(T − 1)α3
AC (T, r) = −
p1 + α3
494 ZHUANG KANG · SRDJAN D. STOJANOVIC

as well as
1   
− 2 wi,1 aρ3,1 + r H1 wi,1 wr ρ2,1 ρ3,1 v − H1 wi,1 wr ρ3,2 v + v − wi,1 ρ3,1
2v
  
−v μi,1 + H0 wi,1 wr ρ3,2 − ρ2,1 ρ3,1 Ai (t, r)
    
+2 − H0 v ρ2,1 2 − 1 wr 2 − H1 rv ρ2,1 2 − 1 wr 2 + rρ2,1 wr

−aρ2,1 wr + vwi,1 ρ3,2 wr + vμr,0 + rvμr,0 Ai (0,1) (t, r)
  
+v Ai (0,2) (t, r)wr 2 + 2 − α1 AC (t, r) + AC (t, r) + Ai (1,0) (t, r)

= −(1 − T )α1 , (35)

Ai (T, r) = 0
and
1
− 2H0 vρ2,1 2 A0 (0,1) (t, r)wr 2 − 2H1 rvρ2,1 2 A0 (0,1) (t, r)wr 2
2v
+2H0 vA0 (0,1) (t, r)wr 2 + 2H1 rvA0 (0,1) (t, r)wr 2 + vA0 (0,2) (t, r)wr 2

+2rρ2,1 A0 (0,1) (t, r)wr − 2aρ2,1 A0 (0,1) (t, r)wr

+2vwi,0 ρ3,2 Ai (0,1) (t, r)wr − 2AC (t, r)vα0 − 2rvA0 (t, r)
     
+2 wi,0 (r − a)ρ3,1 + v μi,0 − H0 + H1 r wi,0 wr ρ2,1 ρ3,1 − ρ3.2 Ai (t, r)

+2vμr,0 A0 (0,1) (t, r) + 2rvμr,1 A0 (0,1) (t, r) + 2vA0 (1,0) (t, r)

= −(1 − T )α0 . (36)

A0 (T, r) = 0
All these PDEs need to be solved on domain −∞ < t < T , −∞ < r < ∞, −∞ < i < ∞,
and −∞ < C < ∞. Equation (34) yields a constant solution:

(T − 1)α3
AC (t, r) = AC = − , (37)
p1 + α3

which is consistent with corresponding terminal condition AC (T, r). It remains to solve Equa-
tions (35) and (36).
Equation (35) is a second order linear PDE with no boundary condition, and with a terminal
condition imposed at T . Therefore, we are looking for the solution in the domain {−∞ < t <
T } × {−∞ < r < ∞}. To that end, we shall use the method that was elaborated in [4]. For
the simplicity of notation, we make the following substitutions:
wi,1 aρ3,1
e0 = μi,1 − + H0 wi,1 wr (ρ3,2 − ρ2,1 ρ3,1 ) ,
v
H1 wi,1 wr ρ2,1 ρ3,1 v − H1 wi,1 wr ρ3,2 v + v − wi,1 ρ3,1
e1 = − ,
v
 INTEREST RATE RISK PREMIUM AND EQUITY VALUATION 495

  aρ2,1 wr
e2 = −H0 ρ2,1 2 − 1 wr 2 − + wi,1 ρ3,2 wr + μr,0 ,
v
  ρ2,1 wr
e3 = −H1 ρ2,1 2 − 1 wr 2 + + μr,1 ,
v

e4 = wr 2 2. (38)
Consequently, the equation for Ai (t, r) becomes

(e0 + e1 r) Ai (t, r) + (e2 + e3 r) Ai (0,1) (t, r) + e4 Ai (0,2) (t, r) + Ai (1,0) (t, r)

= AC (α1 − 1) + (T − 1)α1 . (39)

Ai (T, r) = 0.
Following Harper’s methodology, we first ignore the 2nd order term e4 Ai (0,2) (t, r) and the
terminal condition in equation (39) and set the right hand side to be equal to zero. We obtain
the following linear PDE:

(e0 + e1 r) Ai (t, r) + (e2 + e3 r) Ai (0,1) (t, r) + Ai (1,0) (t, r) = 0, (40)

Solving (40) we obtain one possible form of Ai (denoted as Bi ):

e (e +e r) e e t
 −e3 t 
− 1 e2 2 3 −e0 t+ 1e 2 e (e2 + e3 r)
Bi (t, r) = e 3 3 f
1 , (41)
e3

where, function f1 (·) is an arbitrary differentiable function. The form of the solution Bi (t, r)
now motivates the form of the attempted solution of the Equation (39):
e (e +e r) e e t
 −e3 t 
− 1 e2 2 3 −e0 t+ 1e 2 e (e2 + e3 r)
Ai (t, r) = e 3 3 F
1 ,t , (42)
e3

where function F1 (·) is an unknown function that needs to be determined. We consequently

arrive at

e4 e21 2e−te3 e4 e1 (1,0)

2 F1 (X1 , t) + F1 (0,1) (X1 , t) − F1 (X1 , t) + e−2te3 e4 F1 (2,0) (X1 , t)
e3 e3
−e1 e2 t+e0 e3 t+ee3 t e1 X1
= e e3
(AC (α1 − 1) + (T − 1)α1 ) , (43)

where, for simplicity of notation, we set:

e−e3 t (e2 + e3 r)
X1 = , (44)
e3
however, Equation (43) is not a heat equation, which was the goal of the transformation.
According to Harper’s method, we apply above reduction procedures again on Equation (43):
by ignoring its 2nd order term and setting the right hand side to be equal to zero, we obtain
the following PDE:

e4 e21 2e−te3 e4 e1 (1,0)

2 F1 (X1 , t) + F1 (0,1) (X1 , t) − F1 (X1 , t) = 0. (45)
e3 e3
496 ZHUANG KANG · SRDJAN D. STOJANOVIC

Solving (45), we obtain a possible solution form for F1 (denoted as J1 ):

 
e 2e t
− 1 4 2e−e3 t e1 e4
J1 (X1 , t) = e e3 2 f2 X1 − , (46)
e3 2
where function f2 (·) is an arbitrary differentiable function. The form of the solution J1 (X1 , t)
again motivates the following form of the attempted solution of the Equation (43):
 
e 2e t
− 1e 24 2e−e3 t e1 e4
F1 (X1 , t) = e 3 F2 X1 − , ζ(t) , (47)
e3 2
where, function F2 (·) and ζ(·) are two functions to be chosen. Then the Equation (43) becomes:
   
2e3 t  (0,1) 2e−e3 t e1 e4 (2,0) 2e−e3 t e1 e4
−e ζ (t)F2 X1 − , ζ(t) − e4 F2 X1 − , ζ(t)
e3 2 e3 2
2te3 3 −e1 e2 te3 +ee3 t e1 X1 e3 +e1 2 e4 t
e0 t+
= −e e3 2
(AC (α1 − 1) + (T − 1)α1 ) . (48)
In order to make the equation above a heat equation, we choose the function ζ as:
e−2e3 t e4
ζ(t) = , (49)
2e3
Therefore, by substituting t = log( 2ee34 ζ )/ (2e3 ) and after some simplifications, we can reach
the following equation:
 −e3 t −2e3 t
 −e3 t −2e3 t

F2 (0,1) X1 − 2e e3 2e1 e4 , e 2e3 e4 − F2 (2,0) X1 − 2e e3 2e1 e4 , e 2e3 e4
  
√
2e 3 +e0 e3 2 +e1 2 e4
e1 4e1 e4 ζ+e2 e3 log ( 2ee34 ζ )ζ+ 2e3 e4
e3 ζ
e4
X2
1 − 3
= − 2 2e3 3
e 2e3 3 ζ
e4
  2 2
e3 ζ − e4 e12e+e30 e3 −1
· 3 (AC (α1 − 1) + (T − 1)α1 ) . (50)
e4
The Equation (50) is a forward heat equation. For simplicity of notation, we re-write (50)
as:
√
e1 X2
  
(0,1) (2,0) 2e3
e3 ζ e3 ζ η2
F2 (X2 , ζ) − F2 (X2 , ζ) = e e4
η1 (51)
e4
with variable X2 and constant η1 , η2 :
 
2e−e3 t e1 e4 e−e3 t re3 2 + e2 e3 − 2e1 e4
X2 = X1 − =
e3 2 e3 2

1 2ee1 23e4 − e0 e3 2 +2e 3 2

3 +e1 e4 e1 e2
η1 = − e 3 2 2e3 3
2 2e3 2 (AC (−1 + α1 ) + (−1 + T )α1 ) (52)
e4

−e1 e2 e3 + e3 2 (e0 + 2e3 ) + e1 2 e4

η2 = − ,
2e3 3
Then the solution of Ai (t, r) and F2 (X2 , ζ) have the following relationship:
e4 te1 2 +(−e3 te3 +e2 +e3 r)e1 +e0 e3 2 t
− e3 2
Ai (t, r) = e F2 (X2 , ζ) . (53)
 INTEREST RATE RISK PREMIUM AND EQUITY VALUATION 497

where, F2 has the following initial condition (provided −e0 + e1 − e21 e4 /e23 < 0 and e3 < 0):
 
e−2e3 T e4
F2 X2 , = 0.
2e3
Hereby, we would like to send T → ∞, which implies the arbitrarily specified terminal value
−2e3 T
will be irrelativant for the result. In this case, e 2e3 e4 → −∞, provided e3 < 0. (notice that
assumptions e3 < 0 and −e0 + e1 − e21 e4 /e23 < 0 will be fulfilled under most of realistic market
coefficient values). Therefore, F2 has a zero initial conidition at ζ = −∞:

F2 (X2 , −∞) = 0.

Furthermore, solving the nonhomogeneous heat equation we get

 ζ  ∞ √ e√ 1ξ  
e3 τ e3 τ η2 1 2
e−(x−ξ) 4(t−τ ) dξdτ.
2e3
F2 (X2 , ζ)= e e4
η1  (54)
−∞ −∞ e 4 2 π(t − τ )
Moreover, the inner integral, i.e., the integral with respect to ξ has a closed form solution:
 √ e√ 1ξ  
e3 τ e3 τ η2 1 −(x−ξ)2
2e3
e e4
η1  e 4(t−τ ) dξ
e4 2 π(t − τ )

√ √ e3 τ  
1
e1 e4 ( 2e3
e4
X2 +e1 (ζ−τ ) )√ √ e3 τ η2 − 1
= − √ e 2e3 3 τ
e3 η1 τ 2
2 e4 e4
⎛ ⎞
√   e3 τ √
e4 e3 e4 (X2 − ξ) + 2e1 (ζ − τ )
⎜ ⎟
·erf ⎝ √ √ ⎠. (55)
2e3 3/2 ζ − τ τ

where, the so-called “error function” erf (see [11]) is a the integral of the Gaussian distribution,
z 2
given by erf(z) = √2π 0 e−t dt. Limit of erf function is easy to find:

lim erf(z) = 1, lim erf(z) = −1. (56)

z→∞ z→−∞

√ √
e e3 τ /e4
Inside the erf, ξ has the coefficient − 2√e4 √ζ−τ √ . Assuming that e3 < 0, and with the fact
τ
√ √
3
e4 e3 τ /e4 1
that e4 > 0 and τ < 0, we find out − 2√e √ζ−τ √τ = 2√ζ−τ > 0. Therefore, the limit of ξ → ∞
3
and ξ → −∞ can be found out explicitly, and we conclude the result.
Theorem 3 For the stochastic interest rate model considered in Section 2, and under above
assumptions, the dependency of equity value on the net income rate, denoted by Ai (t, r), is equal
to 2 2
e4 te1 +(−e3 te3 +e2 +e3 r)e1 +e0 e3 t
− e3 2
Ai (t, r) = e F2 (X2 , ζ) , (57)
where
⎛ √ √ e3 τ ⎞
( )√ √  e3 τ − 1 +η2
e1 e4 e1 (ζ−τ )+ 2e3 X2
e4
 ⎜ e
ζ 2e3 3 τ
e3 η1 τ e4 2 ⎟
⎜ ⎟
F2 (X2 , ζ) = ⎜− √ ⎟ dτ, (58)
−∞ ⎝ e4 ⎠
498 ZHUANG KANG · SRDJAN D. STOJANOVIC

and e1 , e2 , e3 , e4 , η1 , η2 , X2 and ζ are from (38), (49), and (52).

The solution Ai (t, r) does not depend on time variable t (for example t = 0 and T → ∞).
Unfortunately, finding A0 (t, r) must be done by means of a numerical solution. Similarly,
the solution of A0 (t, r) shows no t dependency, either. Finally, recall that the company’s value
is equal to
V (t, S, r, i, C) = A0 (t, r) + Ai (t, r)i + AC C,
which completes the equity valuation procedure under the above stochastic interest rate sce-
nario.

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