Cox–Ingersoll–Ross model

In mathematical finance, the Cox–Ingersoll–Ross (CIR) model

describes the evolution of interest rates. It is a type of "one factor
model" (short-rate model) as it describes interest rate movements as
driven by only one source of market risk. The model can be used in
the valuation of interest rate derivatives. It was introduced in 1985
by John C. Cox, Jonathan E. Ingersoll and Stephen A. Ross as an
extension of the Vasicek model.

The model
Three trajectories of CIR processes

The CIR model specifies that the instantaneous interest rate

follows the stochastic differential equation, also named the CIR
Process:

where is a Wiener process (modelling the random market risk

factor) and , , and are the parameters. The parameter
corresponds to the speed of adjustment to the mean , and to
volatility. The drift factor, , is exactly the same as in the
CIR process
Vasicek model. It ensures mean reversion of the interest rate
towards the long run value , with speed of adjustment governed
by the strictly positive parameter .

The standard deviation factor, , avoids the possibility of negative interest rates for all positive values
of and . An interest rate of zero is also precluded if the condition

is met. More generally, when the rate ( ) is close to zero, the standard deviation ( ) also becomes very
small, which dampens the effect of the random shock on the rate. Consequently, when the rate gets close to
zero, its evolution becomes dominated by the drift factor, which pushes the rate upwards (towards
equilibrium).

This process can be defined as a sum of squared Ornstein–Uhlenbeck process. The CIR is an ergodic
process, and possesses a stationary distribution. The same process is used in the Heston model to model
stochastic volatility.

Distribution
Future distribution

The distribution of future values of a CIR process can be computed in closed form:
 where , and Y is a non-central chi-squared distribution with

degrees of freedom and non-centrality parameter . Formally the probability

density function is:

where , , , and is a modified Bessel function

of the first kind of order .

Asymptotic distribution

Due to mean reversion, as time becomes large, the distribution of will approach a
gamma distribution with the probability density of:

where and .

Derivation of asymptotic distribution

 To derive the asymptotic distribution for the CIR model, we must use the Fokker-Planck
equation:

Our interest is in the particular case when , which leads to the simplified equation:

Defining and and rearranging terms leads to the equation:

Integrating shows us that:

Over the range , this density describes a gamma distribution. Therefore, the
asymptotic distribution of the CIR model is a gamma distribution.

Properties
Mean reversion,
Level dependent volatility ( ),
For given positive the process will never touch zero, if ; otherwise it can
occasionally touch the zero point,
, so long term mean is ,

Calibration
Ordinary least squares

The continuous SDE can be discretized as follows

which is equivalent to
 provided is n.i.i.d. (0,1). This equation can be used for a linear regression.

Martingale estimation
Maximum likelihood

Simulation

Stochastic simulation of the CIR process can be achieved using two variants:

Discretization
Exact

Bond pricing
Under the no-arbitrage assumption, a bond may be priced using this interest rate process. The bond price is
exponential affine in the interest rate:

where

Extensions
A CIR process is a special case of a basic affine jump diffusion, which still permits a closed-form
expression for bond prices. Time varying functions replacing coefficients can be introduced in the model in
order to make it consistent with a pre-assigned term structure of interest rates and possibly volatilities. The
most general approach is in Maghsoodi (1996). A more tractable approach is in Brigo and Mercurio
(2001b) where an external time-dependent shift is added to the model for consistency with an input term
structure of rates.

A significant extension of the CIR model to the case of stochastic mean and stochastic volatility is given by
Lin Chen (1996) and is known as Chen model. A more recent extension for handling cluster volatility,
negative interest rates and different distributions is the so-called "CIR #" by Orlando, Mininni and Bufalo
(2018,[1] 2019,[2][3] 2020,[4] 2021[5]) and a simpler extension focussing on negative interest rates was
proposed by Di Francesco and Kamm (2021,[6] 2022[7]), which are referred to as the CIR- and CIR--
models.

See also
Hull–White model
Vasicek model
Chen model

References
1. Orlando, Giuseppe; Mininni, Rosa Maria; Bufalo, Michele (2018). "A New Approach to CIR
Short-Term Rates Modelling". New Methods in Fixed Income Modeling. Contributions to
Management Science. Springer International Publishing: 35–43. doi:10.1007/978-3-319-
95285-7_2 (https://doi.org/10.1007%2F978-3-319-95285-7_2). ISBN 978-3-319-95284-0.
2. Orlando, Giuseppe; Mininni, Rosa Maria; Bufalo, Michele (1 January 2019). "A new
approach to forecast market interest rates through the CIR model". Studies in Economics
and Finance. 37 (2): 267–292. doi:10.1108/SEF-03-2019-0116 (https://doi.org/10.1108%2F
SEF-03-2019-0116). ISSN 1086-7376 (https://www.worldcat.org/issn/1086-7376).
S2CID 204424299 (https://api.semanticscholar.org/CorpusID:204424299).
3. Orlando, Giuseppe; Mininni, Rosa Maria; Bufalo, Michele (19 August 2019). "Interest rates
calibration with a CIR model". The Journal of Risk Finance. 20 (4): 370–387.
doi:10.1108/JRF-05-2019-0080 (https://doi.org/10.1108%2FJRF-05-2019-0080).
ISSN 1526-5943 (https://www.worldcat.org/issn/1526-5943). S2CID 204435499 (https://api.s
emanticscholar.org/CorpusID:204435499).
4. Orlando, Giuseppe; Mininni, Rosa Maria; Bufalo, Michele (July 2020). "Forecasting interest
rates through Vasicek and CIR models: A partitioning approach" (https://onlinelibrary.wiley.c
om/doi/10.1002/for.2642). Journal of Forecasting. 39 (4): 569–579. arXiv:1901.02246 (https://
arxiv.org/abs/1901.02246). doi:10.1002/for.2642 (https://doi.org/10.1002%2Ffor.2642).
ISSN 0277-6693 (https://www.worldcat.org/issn/0277-6693). S2CID 126507446 (https://api.s
emanticscholar.org/CorpusID:126507446).
5. Orlando, Giuseppe; Bufalo, Michele (2021-05-26). "Interest rates forecasting: Between Hull
and White and the CIR#—How to make a single‐factor model work" (https://doi.org/10.100
2%2Ffor.2783). Journal of Forecasting. 40 (8): 1566–1580. doi:10.1002/for.2783 (https://doi.o
rg/10.1002%2Ffor.2783). ISSN 0277-6693 (https://www.worldcat.org/issn/0277-6693).
6. Di Francesco, Marco; Kamm, Kevin (4 October 2021). "How to handle negative interest rates
in a CIR framework". SeMa Journal. 79 (4): 593–618. doi:10.1007/s40324-021-00267-w (htt
ps://doi.org/10.1007%2Fs40324-021-00267-w). S2CID 235358123 (https://api.semanticscho
lar.org/CorpusID:235358123).
7. Di Francesco, Marco; Kamm, Kevin (2022). "On the Deterministic-Shift Extended CIR Model
in a Negative Interest Rate Framework" (https://doi.org/10.3390%2Fijfs10020038).
International Journal of Financial Studies. 10 (2): 38. doi:10.3390/ijfs10020038 (https://doi.or
g/10.3390%2Fijfs10020038).

Further References
Hull, John C. (2003). Options, Futures and Other Derivatives (https://archive.org/details/optio
nsfuturesot00hull_1). Upper Saddle River, NJ: Prentice Hall. ISBN 0-13-009056-5.
 Cox, J.C., J.E. Ingersoll and S.A. Ross (1985). "A Theory of the Term Structure of Interest
Rates". Econometrica. 53 (2): 385–407. doi:10.2307/1911242 (https://doi.org/10.2307%2F19
11242). JSTOR 1911242 (https://www.jstor.org/stable/1911242).
Maghsoodi, Y. (1996). "Solution of the extended CIR Term Structure and Bond Option
Valuation". Mathematical Finance. 6 (6): 89–109. doi:10.1111/j.1467-9965.1996.tb00113.x
(https://doi.org/10.1111%2Fj.1467-9965.1996.tb00113.x).
Damiano Brigo; Fabio Mercurio (2001). Interest Rate Models — Theory and Practice with
Smile, Inflation and Credit (2nd ed. 2006 ed.). Springer Verlag. ISBN 978-3-540-22149-4.
Brigo, Damiano; Fabio Mercurio (2001b). "A deterministic-shift extension of analytically
tractable and time-homogeneous short rate models" (http://ideas.repec.org/a/spr/finsto/v5y20
01i3p369-387.html). Finance & Stochastics. 5 (3): 369–388. doi:10.1007/PL00013541 (http
s://doi.org/10.1007%2FPL00013541). S2CID 35316609 (https://api.semanticscholar.org/Cor
pusID:35316609).
Open Source library implementing the CIR process in python (https://github.com/Alexandre
Moulti/bachelier)
Orlando, Giuseppe; Mininni, Rosa Maria; Bufalo, Michele (2020). "Forecasting interest rates
through Vasicek and CIR models: A partitioning approach". Journal of Forecasting. 39 (4):
569–579. arXiv:1901.02246 (https://arxiv.org/abs/1901.02246). doi:10.1002/for.2642 (https://
doi.org/10.1002%2Ffor.2642). ISSN 1099-131X (https://www.worldcat.org/issn/1099-131X).
S2CID 126507446 (https://api.semanticscholar.org/CorpusID:126507446).

Retrieved from "https://en.wikipedia.org/w/index.php?title=Cox–Ingersoll–Ross_model&oldid=1146694618"