Models

A survey of current frameworks for yield-curve modeling and the pricing of fixed-income options

Marco Avellaneda New York University

Summary of this presentation

Term-structure of Interest Rates Fixed-income markets Yield-curve stripping and smoothing Stylized facts about motions Stochastic interest rate models Ho & Lee Vasicek Hull-White CIR

1 Summary of this presentation

Pricing European-style options Forward Measure – Black 1976 methodology Parametric versus Black-Scholes volatility

Forward Rate Models Heath-Jarrow-Morton Brace-Gatarek-Musiela Correlation and Covariance Implementation Issues & Methodologies

Conclusions

Term Structure of Interest Rates

2 Fixed-Income Markets

Government Debt (U.S., G7) Tax-exempt debt (Municipalities) Mortgage-Backed Securities Corporate Debt – Investment Grade

High-Yield Corporate Debt (Junk bonds) (U.S. / local currencies)

Derivatives Listed Markets Dealer (OTC) Market

US Treasury Debt Benchmarks On the run securities: 3m, 6m, 1y, 2y, 5y, 10y, 30y

Previous Current Bills Mat Date Price/Yield P rice/Yield Yld Chg P rc Chg 3month 7/26/01 3.65 (3.74) 3.70 (3.79) 0.05 +5 6month 10/25/01 3.64 (3.76) 3.65 (3.77) 0.01 +1 1year 2/28/02 3.59 (3.73) 3.60 (3.74) 0.01 +1 Notes/ Previous Current Bonds Mat Date Price/Yield P rice/Yield Yld Chg P rc Chg 2year 4.250 3/31/03 100-07+ (4.12) 100-06+ (4.14) 0.02 --0-01 5year 5.750 11/15/05 104-11 (4.68) 104-08+ (4.70) 0.02 --0-03 10year 5.000 2/15/11 98-21 (5.18) 98-17 (5.19) 0.02 --0-04 30year 5.375 2/15/31 95-03+ (5.72) 94-30 (5.73) 0.01 --0-06

Inflation Previous Current Indexed Treasury Coupon Mat Date Price/Yield P rice/Yield Yld Chg P rc Chg 5year 3.625 7/15/02 102-02 (1.91) 102-05+ (1.82) -0.09 +0-03+ 10year 3.500 1/15/11 101-15 (3.32) 101-24 (3.29) -0.03 +0-09 30year 3.875 4/15/29 105-17 (3.56) 105-31 (3.54) -0.02 +0-14

Source: Bloomberg

3 (XURGROODU)XWXUHV'DLO\3ULFHV

Contract Las t Change Open High Low Volume Open Int. May '01 (EDK01) 95.7875 0.0525 95.78 95.795 95.765 0 0 Jun '01 (EDM01) 95.88 0.055 95.84 95.89 95.83 0 0 Jul '01 (EDN01) 95.92 0.065 95.925 95.93 95.92 0 0 Aug '01 (EDQ01) 95.93 0.08 0 95.93 95.93 0 0 Sep '01 (EDU01) 95.945 0.08 95.87 95.95 95.87 0 0 Oct '01 (EDV01) 95.795 0.115 95.71 95.795 95.71 0 0 Dec '01 (EDZ01) 95.69 0.095 95.635 95.7 95.625 0 0 Mar '02 (EDH02) 95.495 0.1 95.435 95.505 95.425 0 0 Jun '02 (EDM02) 95.185 0.09 95.14 95.2 95.125 0 0 Sep '02 (EDU02) 94.92 0.08 94.87 94.93 94.87 0 0 Dec '02 (EDZ02) 94.645 0.085 94.595 94.65 94.59 0 0 Mar '03 (EDH03) 94.52 0.085 94.47 94.535 94.465 0 0 Jun '03 (EDM03) 94.365 0.085 94.3 94.37 94.3 0 0 Sep '03 (EDU03) 94.265 0.085 94.2 94.27 94.2 0 0

Forward-rate-Agreements FRA = agreement to enter into a loan in the future

$100

t ∆t

$100*(1+∆ t F)

$100*(1+ ∆ t R)

FRA= 1 period swap t ∆t in arrears

$100*(1+ ∆ t F)

4 Interest Rate Swap

6-M LIBOR Firm 6.52 % 2

Swap Dealer 6-M LIBOR Firm 1 6.42 %

Swap Benchmark Rates

Se curity S wp Rt S wp S pd S pd Chg

US D 2 YR S WAP 4.7 57.25 -0.75

US D 5 YR S WAP 5.474 77.75 0

US D 10 YR S WAP 6.047 84.5 0.25

US D 30 YR S WAP 6.506 75.5 -0.25

Fixed Rate

6-M LIBOR

5 Swaps & Par Bonds

Swaps are ``derivatives’’ in the sense that the holder is not purchasing debt. Cash-flows depend on the difference between financing rates at inception and financing rates in the future.

Standard swaps (with LIBOR resets) can be priced as par bonds.

Floating rate is worth par

= 100

100 + = LIBOR

100 + F 100

= 100 + F

Fixed rate payer =Long $100, short bond with face value $100

6 Summary of US Dollar market: a dealer’s perspective

T-Bond and T-Bill futures (CBOT)

Interest rate futures (ED)

U.S. Treasury bonds

Swaps

Options: bond options, swaptions

No-arbitrage: existence of discount factors

One interest rate per maturity => Existence of a discount curve

P(T ) = present val. of cash flow of $1 in T

P(T)

T

7 Spot Curve of Discount Factors Nov 1997

1.2

1

0.8 1 $ f o 0.6

V P 0.4

0.2

0 1 9 7 5 3 1 9 7 5 3 1 9 7 5 3 1 9 7 5 3 1 0 1 3 5 7 9 2 4 6 8 9 1 3 5 7 8 0 2 4 6 1 1 1 1 1 1 2 2 2 2 2 3 3 3 3 month

Forward-rate curve and Discount curve f(T)

T d f (T ) = − log P(T ) dT

 T    P(T ) = exp− ∫ f (t)dt  0 

8 Spot Forward Rate Curve f(0;T) Nov 1997

6.8

6.6

6.4 t n 6.2 e c r e

P 6

5.8

5.6

5.4 5 4 3 2 1 0 9 8 7 6 5 4 3 0 9 8 7 6 1 1 3 5 7 9 1 2 4 6 8 0 2 4 2 3 5 7 9 1 1 1 1 1 2 2 2 2 2 3 3 3

Month

Pricing Future Cash-Flows

f(T)

c T 1 c3 c4

Portfolio represented t by future cash-flows c2 c5

9 Pricing Cash-Flows f(T)

T

Ti − ∫ f (t )dt = 0 Fair Value of Portfolio ∑cie i

Yield curve stripping Find a piecewise-constant FR curve that prices a universe of benchmark bonds correctly

Tij Ni   = − ( )  = Bi ∑cij exp ∫ f t dt i 1,..., M j=1  0 

f f2 3 f τ = T 1 i iNi

τ τ τ Bond 1 2 3 maturities

10 Bootstrapping: solve for forward rates recursively

− = f1T1 j B1 ∑c1 je ≤τ T1 j 1

− − τ − ( −τ ) = f1T2 j + f1 1 f2 T2 j 1 B2 ∑c2 je ∑c2 je ≤τ τ < ≤τ T2 j 1 1 T2 j 2 ......

M −1 − ∑ f (τ −τ − )− f (T −τ − ) − f T i i i 1 M Mj M 1 = 1 Mj + i=1 BM ∑cMje ∑cMje ≤τ τ < ≤τ TMj M −1 M −1 TMj M

At each step, we have a decreasing function of the unknown rate: unique solution

Pricing Date: 17-Apr-01 Last Next Effective Payment Payment Approximate Annual Bond Coupon Date Date Date Price Yield Invoice Price Yield

3m 0 7/18/01 NA NA 4.660 4.660 NA 4.714% 6m 0 10/18/01 NA NA 4.560 4.560 NA 4.612% 2y 5.00 1/12/03 1/12/01 7/12/01 100.790 4.504 102.102 4.555% 3y 4.50 7/12/03 1/12/01 7/12/01 99.980 4.501 101.161 4.552% 4y 3.50 7/12/04 1/12/01 7/12/01 96.880 4.555 9 7.799 4.607% 5y 5.00 1/12/06 1/12/01 7/12/01 101.390 4.701 102.702 4.756%

5.100%

5.000% 4.900% 4.800% Example: 4.700% 4.600% Stripping a 4.500% dataset with 6 4.400% bonds 4.300%

4.200% 4/17/01 - 7/18/01 - 10/18/01 - 1/12/03 - 7/12/03 - 7/12/04 - 7/18/01 10/18/01 1/12/03 7/12/03 7/12/04 1/12/06

11 Yield curve smoothing

Find f(t) which is smooth (no jumps) and consistent with the market.

Continuous model Minimize over f:

2  Tij   − ∫ f (s)ds  2 Tmax − 0 + ε ( ( )) ∑ Bi ∑cije  ∫ f ' t dt 0 i  j   

Sum of squared errors ``Penalty’’ term

Smoothing Algorithm: curve is piecewise constant with small intervals between jumps

( ) = − ∆ < ≤ ∆ = f t fk (k 1) t t k t k 1,2,..., N max

(f ,..., f ) Minimize over 1 Nmax

2  Nij  − ∆ N 2  ∑ fk t  max − k =1 + ε ( − ) ∆ ∑ Bi ∑cije  ∑ fk fk−1 t   = i  j  k 1

12 Minimization can be done with standard tools: e.g. Solver

Delta T = 3 months; Epsilon=0.333

5.00% 4.90% 4.80% 4.70% 4.60% 4.50% 4.40% 4.30% 4.20%

1 1 2 2 2 2 3 3 3 3 4 4 4 4 5 5 5 5 6 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 l- t- - r- l- t- - r- l- t- - r- l- t- - r- l- t- - u c n p u c n p u c n p u c n p u c n J O Ja A J O Ja A J O Ja A J O Ja A J O Ja 3 month period ending

Error is less than 0.001 on all bonds & zeros

Regularization and splines

ΠSplines=piecewise-polynomial curves

ŒPenalty/ regularization methods correspond to polynomial splines

Œ The optimal ``splining knots’’ are located at the coupon dates of the input bond/swap data.

ΠSplining methods with too few knots can give rise to unstable curves

13 Stochastic Interest Rate Models & Option Pricing

Evolution of Benchmark Swap Rates

9.00 8.50 8.00 7.50 1 YR 7.00 5YR 6.50 10YR 6.00 30YR 5.50 5.00 4.50 4.00 5 5 6 6 7 7 8 8 9 9 0 0 1 9 9 9 9 9 9 9 9 9 9 0 0 0 / / / / / / / / / / / / / 3 3 3 3 3 3 3 3 3 3 3 3 3 / / / / / / / / / / / / / 1 7 1 7 1 7 1 7 1 7 1 7 1

14 US Treasury Yield Curve: Mar 1986 -June 1988

9-11 7-9 5-7

1 3-5 1

9 ) % (

7

e t a r 6 -8 7 r 5 a -8 n 8 -M u -8 3 J p 9 - e -8 2 S c 1 - e -9 2 D r 2 - a -9 1 M n 3 - u -9 3 1 J 5 - p -9 2 e 6 -S n a 9 y 2 J r- 7 - a 9 3 2 - m M 8 - n 9 3 1 u - -J n 2 u -J 3

Caps and Floors

ΠSeries of options on 3-month LIBOR rates

ΠSeries of options on 3-month discount bonds

Swaptions

ΠOption on a swap

ΠOption on a series of 3-month discount bonds

15 Caps

X 1 X2 X3 X4

where xi = max ( Ri –F, 0)

Receiver 5x10 Swaption

exercise t =15 6-M LIBOR

0 t =5

no exercise 0 t =15

Swaption expiration date

16 Markovian one-factor models

ΠEvolution of sort-term interest rates is modeled using a

dX (t) = σ (X (t),t)dZ(t)+ µ(X (t),t)dt

r(t) = R(X (t)) = short - term interest rate

Markovian one-factor models

ΠEvolution of all forward rates is obtained from the fact that discount factors are functions of the state variable (hence of r(t))

P(t;T ) = present value of a future cash - flow of $1 paid at time T, evaluated at time t

 T   −∫ r(s )ds  P(t;T ) = Ee t X (t) = Z(t, X (t);T )    

17 Ho-Lee, 1986 Ho-Lee Model J. Finance

ΠShort rate follows Brownian motion (continuous ) with drift

ΠDrift is adjusted to fit the current term structure of interest rates

dr(t) = σdW (t)+ µ(t)dt

t r(t) = r(0)+σW (t)+ ∫ µ(s)ds 0 = σW (t)+ b(t)

Ho-Lee Model

T  T  −∫ f (s)ds  −∫ r(s)ds  P(0;T ) = e 0 = Ee 0      Known from yield curve data

18 Ho-Lee Model

T  T  −∫ f (s)ds  −∫ r(s)ds  P(0;T ) = e 0 = Ee 0      Unknown  T  T  −∫σW (s)ds  −∫ b(s)ds = Ee 0 e 0    

T σ 2T 3 −∫ b(s )ds =e 6 e 0 Solving for b(s)

T σ 2T 3 T σ 2t 2 ∫ f (s)ds = + ∫b(s)ds b(t) = f (t)+ 0 6 0 2

Ho-Lee Model

ΠDrift of short rate process is a function of the derivative of forward rate curve

σ 2t 2 r(t) = σW (t)+ f (t)+ 2

dr(t) = σdW (t)+ µ(t)dt, µ(t) = f '(t)+σ 2t

19 Discount factors & Forward Rates

Zero-coupon bond T − f (s)ds σ 2 price is obtained in ∫ −σ (T −t )W (t )+ (T −t )Tt ( ) = t × 2 explicit form P t;T e e

σ 2t 2 Simple forward rate f (t;T ) = f (T )+σW (t)− +σ 2tT dynamics 2

Simple structure for ( ) dP t;T = −σ ( − ) ( )+ the volatility of discount ( ) T t dW t r(t)dt factors P t;T

Ho-Lee Model: standard positions of f(1,T), W(1)=+1 the forward rate curve f(1,T) W(1)= -1 f(0,T) 7.5

7 t

n 6.5 e c r e p 6

5.5

5 1 23 45 67 89 111 133 155 177 199 221 243 265 287 309 331 353 month (T*12)

20 O. Vasicek, Vasicek’s Model 1977, J.F.E.

Œ ``Equilibrium model’’ as opposed to an ``arbitrage model’’: seeks to explain the shape of the yield curve

dr(t) = σdW (t)+ κ (r∞ − r(t))dt

t ( ) = −κt ( )+ ( − −κt ) + σ −κ (t−s) ( ) r t e r 0 1 e r∞ ∫ e dW s 0

σ = volatility, κ = speed of mean - reversion,

r∞ = long - term average rate

Mean-reversion

Short rate has an asymptotic distribution with finite variance

r∞

µ = r r(0) ∞ ∞ σ 2 2 σ ∞ = 2κ

t

21 Parameter Estimation

Chen & Scott: Estimation of parameters with Treasury data 1988-1993

κ = 0.2456

r∞ = 6.48% σ = 2.9%

Discount Factors & Forward Rates

ΠExplicit formulas

ΠSimplistic forward rate structure

− ( ) ( )− ( ) P(t;T ) = e A t;T r t B t;T

−κ ( − ) 1− e T t A(t;T ) = ; κ

 σ 2  σ 2 ( )2 ( ) =  − ( − − ( ))+ A t;T B t;T r∞  T t A t;T  2κ 2  4κ

22 Volatility Structure in the Vasicek model

( ) df (t;T ) = σe−κ T −t) dW (t)+ drift term

Forward rate volatility is ``damped’’ as maturity increases

( ) dP(t;T ) 1− e−κ T −t  = σ  dW (t)+ r(t)dt P(t;T )  κ 

Bond volatility is bounded as T increases

Vasicek Model: initial forward rate curve

σ 2 −κt −κt −κt 2 f (t) = r(0)e + r∞ (1− e )− (1− e ) 2κ 2

Exponential spline Convexity correction connecting current spot rate to asymptotic rate (expected spot rate

23 Vasicek forward rate curves r_0=4.5% r_5yr=4.79%, sig=3% 4.85

4.8

4.75

4.7

4.65

4.6 kappa=0.25 4.55 kappa=0.01

4.5

4.45

0 .3 .6 .9 .2 .5 .8 .1 .4 .7 3 .3 .6 .9 .2 .5 .8 0 0 0 1 1 1 2 2 2 3 3 3 4 4 4

Hull & White 1992 Hull-White / Modified Vasicek Model

ΠRetains the desirable mean-reverting property of the Vasicek model

ΠMatches the current term structure of interest rates

dX (t) = −κX (t)dt +σdW (t), X (0) = 0

Ornstein-Uhlenbeck ( ) = ( )+ ( ) process with drift r t X t b t correction

dr(t) = σdW (t)+ κ (r∞ (t)− r(t))dt

24 Spot & forward rate dynamics: Modified Vasicek

t −κ ( − ) X (t) = σ ∫ e t s dW (s) 0 2 σ 2 r(t) = X (t)+ f (0;t)+ (1− e−κt ) 2κ 2

−κ ( − ) f (t;T ) = e T t X (t)+ f (0;t)+ C(t;T ) 2 σ −κ 2 −κ ( − ) 2 C(t;T ) = [(1− e T ) − (1− e T t ) ] 2κ 2

Application of Short-rate Models ``Convexity adjustment’’ in futures vs. forward rates

Œ Rates implied by ED futures contracts are higher than forward rates Φ(T,∆T ) = E[R(T ,∆T )] Futures-implied rate (settles on term rate)

1  P(T )  Forward rate F(T,∆T ) =  −1 ∆T  P(T + ∆T ) 

T  − ( )  1  ∫ r s ds  = E e 0 R(T,∆T ) P(T ) t    

25 Approximate term rates with instantaneous rates and use explicit formula

R(T,∆T ) ≅ r(T ) Φ(T,∆T ) ≅ E(r(T )) F(T,∆T ) ≅ f (0;T ) σ 2 −κt 2 From r(t) = X (t)+ f (0;t)+ (1− e ) Vasicek model 2κ 2

2  σ −κ 2  Φ(T,∆T ) = E X (T )+ f (0;T )+ (1− e T )   2κ 2  2 σ 2 ≅ F(T,∆T )+ (1− e−κT ) 2κ 2

November 1997 data CONVEXITY ADJUSTMENT: EURODOLLAR FUTURES

Maturity (months)Futures price Convexity Adjustment (%) 4 94.19 0.0012 10 94.14 0.0023 13 94.08 0.003 16 93.98 0.0044 19 93.98 0.0092 22 93.94 0.0131 25 93.91 0.0176 28 93.85 0.0234 31 93.87 0.0232 34 93.85 0.0371 37 93.83 0.0447 40 93.74 0.0522 43 93.79 0.0637 46 93.77 0.073 49 93.75 0.083

26 Future-Implied minus Forward ED 3-month rates

9 8 7

s 6 t Theoretical n i

o 5 p 2 2 s

i 4 σ

s t a Φ − F ≅ B 3 2 2 1 0 4 10 13 16 19 22 25 28 31 34 37 40 43 46 49 Forward Maturity (in months)

Sqrt(Futures-Forwards)/Time Implied sigma

0.1 0.09 y = 0.0001x + 0.0538 0.08 R2 = 0.0039 2 2 − σ  49  0.07 8.3×10 4 =   0.06 2  12  0.05 0.04 2 −4 0.03 2 × (12) ×8.3×10 σ = ≅ 1% 0.02 (49)2 0.01 0 4 10 13 16 19 22 25 28 31 34 37 40 43 46 49 Forward Maturity (in months)

f(1;T); X(1)=+sig; Hull-White 1-factor model: 1-std displacements of f(0;T) the forward rate curve in one year f(1;T); X(1)= -sig

6.8 6.6 6.4 6.2 )

% 6 (

e t 5.8 a r 5.6 5.4 5.2 5 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 0 1 2 3 4 5 6 7 8 9 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 1 1 1 1 1 1 1 1 1 1 2 2 2 2 2 2 2 2 2 2 3 3 3 3 3 3 months (T*12)

27 Cox, Ingersoll & Ross, 1985

CIR/Modified CIR

ΠShort rate follows square-root diffusion

dr(t) = σ r(t)dW (t)+ κ (r∞ − r(t))dt

ΠSquare root diffusion prevents the rate from becoming negative

ΠDistribution of rate is non-central chi squared

Non-central Chi-squared vs. Gaussian

ΠNon-central chi-squared is positively skewed; it can be thought as the distribution of a sum of n squares of independent normals

n = number of degrees of freedom κ = 4 r∞ σ 2

× × ≅ 4 0.24 0.0648 = Essentially From Chen-Scott: n 2 79.34 (0.028) Gaussian!

28 The asymptotic density of rates for different parameter values

1 2 Y0 κr∞ ≥ σ 2

1 2 0 <κr∞ < σ Y0 2

τ 0

Y0 κr∞ ≤ 0

Density for r(t) : square-root model . r0=5.5%, sigma=3%, kappa=0.25, r_inf=6.8%

90 80 70 ) t=0.5 Y

, 60 t t=2 , 50 5

5 40 t=5 0 .

0 30 t=10 ( p 20 t=20 10 0 1 2 2 3 3 4 4 5 5 6 6 7 7 8 8 9 9 1 1 1 1 2 2 3 3 4 4 5 5 6 . . 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 1 1 1 1 1 1 1 1 1 1 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 Y(t)

29 Densities for r(t): r0=9.5%, sigma=3%, kappa=0.25,r_inf=5.5%

70 60 t=0.5 ) 50 Y

, t=2 t , 40 5 t=5 9

0 30 . t=10 0 ( 20 p t=20 10 0 6 5 4 3 2 1 9 1 8 7 6 5 4 3 2 1 . 1 1 1 1 1 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 Y

CIR: forward rates & Discount factors

P(t;T ) = e− A(t;T )r(t)−B(t;T )

( ) 2(1− e−α T −t ) A(t;T ) = ( ) α + κ + (α −κ )e−α T −t α = κ 2 + 2σ 2

Exponential-affine structure for zero-coupon bonds

30 Common Features of One-factor Models

ΠShort rates follow 1-D diffusions: easy to implement by Monte Carlo or finite-differences (lattices)

ΠForward rates shocks are perfectly correlated with short rate shocks (albeit with different amplitudes according to mean-reversion/damping of vol)

ΠCan be calibrated to the current term structure of interest rates easily

ΠMain interest: heuristic value, pricing American option & other PDE problems

Main differences

ΠHo-Lee and its discrete analogue, B-D-T, fit the term structure of interest rates but do not have mean-reversion of short rates.

Œ Vasicek and CIR are ``equilibrium models’’ that do not fit the current term structure of interest rates. However, they can be modified by adding a time-dependent drift to fit the term structure (Hull-White)

ΠModified Vasicek has Gaussian short rates and lognormal zero-coupon bonds. Very tractable.

Œ CIR ``enforces’’ positive rates but is analytically cumbersome. High number of degrees of freedom in practice.

31 Pricing Future Cashflows

 T   −∫ r(s)ds  V (r,t) = Ee t F(r(T ))r(t) = r    

∂V σ 2 (r,t) ∂2V ∂ V + + µ(r,t) − rV = 0 ∂t 2 ∂r2 ∂r

V (r,T ) = F(r)

Fokker-Planck equation

Markov 1 factor models: numerical algorithm

Stochastic differential equation dr(t) = σ (r(t))dW (t)+ µ(r(t),t)dt

= +σ ( ) ∆ + µ( )∆ Discrete approximation rn+1 rn rn Nn+1 t rn ,t t

Implementation: Monte Carlo of finite-differences (PDE)

32 Finite-difference (PDE) implementation of 1-factor models

3-pt stencil probabilities or weights

+σ ∆ 1 σ 2 (r) µ(r,t)  r 0 t p =  − ∆t  u  σ 2 σ  2  0 0  σ 2 (r) p = 1− r r m σ 2 0 1 σ 2 (r) µ(r,t)  p =  + ∆t  d  σ 2 σ  −σ ∆ 2  0 0  r 0 t

Explicit/ Implicit Schemes, CFL

Solving the backward Fokker- Planck equation

Payoff At Maturity Value Today Finite-difference Scheme C C observed PU

S0 PM

PL C(S , 0) 0 t S t K S S0 K

S0 = today’s price

K = strike price Ct + LC = 0

33 Solving the forward Fokker- Planck equation Probability Density Dirac Mass Finite-difference Scheme Function p p PU

S0 PM

PL

t x Y t x Y

* Pt - L P = 0

Monte Carlo Simulation

= +σ ( ) ∆ × + µ( )∆ rn+1 rn rn ,tn t snorm( ) rn ,tn t

snorm( ) = pseudo - random number generator for standard normals

34 Closed-form solutions for bond options and volatility modeling

Call option on a zero-coupon bond

C = value of the call option K = exercise price T = time to expiration T + ∆T = maturity date of the bond (paying $1)

Pricing formula: using the ``risk-neutral’’ measure

 T   −∫ r(s)ds  C = Ee 0 max(P(T;T + ∆T )− K,0)    

35 Pricing formula: using the ``risk-neutral’’ measure

 T   −∫ r(s)ds  C = Ee 0 max(P(T;T + ∆T )− K,0)    

Discounting Payoff term (interest rate sensitive) (interest rate sensitive)

Dynamics of Forward Prices

= Vt value of security that pays no divs. until time T = FVt forward value of this security for delivery at time T V FV = t t P(t;T )

dFVt = σ * F dWt under a new probability P FVt

2 2 2 σ F = σ − 2σ σ ρ +σ V V P P (Think about the vol. of the ratio of V and P)

36 Calculation of Forward Volatilities

ΠSince bond movements are perfectly correlated in 1F models

σ = σ σ = σ V P(.;T +∆T ) P P(.;T ) ∴ σ = σ −σ F P(.;T +∆T ) P(.;T )

Ho-Lee

σ = σ ( + ∆ − )−σ ( − ) = σ∆ F T T t T t T

Hull-White-Vasicek

 − −κ (T +∆T −t )   − −κ (T −t )  σ ( ) = σ 1 e  −σ 1 e  F t      κ   κ   − −κ∆T  −κ (T −t ) 1 e = σe    κ 

Term volatility

T  − −κ∆T  − −2κT 1 2 1 e 1 e σ = σ T(t)dt=σ  T ∫  κ  κ T 0   2 T

37 = + ∆ FPt T - forward value of the bond with maturity T T = P(t;T + ∆T )/ P(t;T ) = FCt T - forward value of the option with maturity T = C(t)/ P(t;T )

C(0)  C(T )  = E*  = E* (max(P(T;T + ∆T )− K,0)) P(0;T )  P(T;T )

P(0;T + ∆T )  1   1  P(T;T + ∆T ) = expσ N T − σ 2T  = FP(0)expσ N T − σ 2T  P(0;T )  T 2 T   T 2 T 

( ) = ( )[ × ( )− × ( )]= ( σ ) C 0 P 0;T FP N d1 K N d2 BSCall P, K,T,r,0, T

Volatility Calibration

ΠForward measure formalism gives rise to Black 76 type pricing for bond options and caplets

(σ κ ) Œ Simple formulas relate the model parameters , to marker prices by inverting the Black Scholes formula

ΠGaussian models treat bond prices as lognormal. This is somewhat different from the market quoting convention, (lognormal rates) but price-to-price calibration is easy.

(σ ( ) κ ( )) Œ Time-dependent t , t are often used to calibrate to several option prices simultaneously.

38 Forward rate models & multifactor analysis

Why models based on movements of forward rates?

Œ Early 1990’s brings period of low interest rates and emergence of structured products & exotics

Œ Options on the ``slope’’ of the yield curve

ΠMortgage-backed securities

ΠLong-dated American-style interest rate options (Bermudans)

39 US Treasury benchmark yields

10 9 3m 8 6m 1y ) 7 %

( 2y

d 6 l 3y e i y 5 5y 10y 4 30y 3 2 6 7 8 9 0 1 2 3 4 5 6 7 8 8 8 8 8 9 9 9 9 9 9 9 9 9 / / / / / / / / / / / / / 2 2 2 2 2 2 2 2 2 2 2 2 2 / / / / / / / / / / / / / 1 1 1 1 1 1 1 1 1 1 1 1 1

Three US Treasury Yield Curves in the 1990's

9 8 7

d 6 l e i

y 5

4 31-Dec-90 3 30-Jun-93 27-Jul-98 2 3m 6m 1y 2y 3y 5y 10y 30y maturity

40 Models need to reflect the correlations of forward rates

ν ( ) = α( ) + β ( ) ( )+ df t;T t;T dt ∑ t;T dWk t .... k=1

ΠChanges in the shape of the forward rate curve are driven by several independent factors (having different amplitudes)

ΠMain deformation modes can be estimated from historical data (Principal Component Analysis)

US Treasury yield curve: Normalized Principal Components for quarterly shocks

0.8 0.6

t 0.4 n e 0.2 88.70% m e c 0 8.90% a l p -0.2 1.41% s i d -0.4 -0.6 -0.8 3m 6m 1y 2y 3y 5y 10y 30y maturity

41 Heath-Jarrow-Morton approach

Œ Puts emphasis on the volatility and correlation of forward rates (analogy with Black-Scholes, Black ’76, etc)

ΠFor any given volatility/correlation structure, HJM gives the correct drift on the forward rate curve needed to have a risk-neutral measure

ΠA systematic approach to fit the initial term-structure of interest rates for any vol/corr structure

HJM Equation

Assume that the forward rate curve has the following dynamics:

ν ( ) = β ( ) ( )+α( ) df t;T ∑ k t;T dWk t t;T dt k=1

This model is a risk-neutral pricing measure if and only if

ν T α( ) = β ( ) β ( ) t;T ∑ k t;T ∫ k t;s ds k =1 t

42 ``Lognormal’’ HJM

df (t;T )  ν  = σ (t;T ) ∑ψ (T − t)dW (t) + µ(t;T )dt ( )  k k  f t;T  k=1 

ν ψ 2 ( ) = ∑ k x 1 k=1

Three correlation factors

1.2 Parallel shift 1

0.8 Psi1(x) 0.6 Psi2(x) Psi3(x) Bend 0.4

Tilt 0.2

0

.1 .4 .7 1 .3 .6 .9 .2 .5 .8 .1 .4 .7 4 .3 .6 .9 0 0 0 1 1 1 2 2 2 3 3 3 4 4 4

43 SWAPTION MODEL

maturity tail strike 2-factor Ho-Lee 1 0.25 4.824 7.6 7.9 2 0.25 5.096 11.8 12.1 5 0.25 5.669 16.9 17.2 1 5 5.273 206.3 209.8 2 5 5.357 256 258.9 5 5 5.684 290.6 294.8 1 10 5.481 506.3 514.2 2 10 5.676 516.6 524.4 5 10 5.998 588.6 599.1

Brace-Gatarek-Musiela model

F F 1 2 Fn

T T T T 1 2 T3 4 N

ΠN fixed consecutive dates (say, 3 months apart)

Œ Consider the evolution of forward rates for loans over periods ( ) = − Tn ,Tn+1 , n 1,..., N 1

1  P(t,T )  F (t) =  n −1 n ∆  ( )  T  P t,Tn+1 

44 BGM Equations

Dynamics for dF (t) n = σ (t)dW (t)+ µ (t)dt ( ) n n n forward rates Fn t

n ∆tF (t) µ (t) = σ (t)∑ m σ (t) ``Risk-neutral’’ drift n n + ∆ ( ) m m=2 1 tFm t

( ) ( ) W1 t ,....,WN t are correlated Brownian motions

BGM / HJM Implementation

ΠMethod of choice: Monte Carlo simulation

ΠAdvantage: volatilities of forward rates are easy to calibrate from Cap/Floor/Swaption quotes

ΠDisadvantage: correlations between rates are difficult to measure precisely. Dimensional reduction needed.

ΠDisadvantage: Evaluating American options requires sophisticated methods and approximation of the exercise region

45 BGM and HJM are not very different in practice… Discrete lognormal HJM

 n  ( + ∆ ) = ( )+ ( )σ ( ) ( ) ∆ +  ( )σ ( ) ( )σ ( )∆ ∆ fn t t fn t fn t n t N t t fn t n t ∑ fm t m t t t  2 

Discrete BGM

 n f (t)σ (t)∆t  f (t + ∆t) = f (t)+ f (t)σ (t)N (t) ∆t +  f (t)σ (t)∑ m m ∆t n n n n  n n + ( )σ ( )∆   2 1 f m t m t t 

Difference in drift is higher-order correction term!

``Cherchez la correlation’’

ΠDifficulties in MF models are not in choice of model per se: they reside in the computational complexity and the difficulty of calibration of volatility/correlation

ΠRecent developments such as Least Squares Monte Carlo, allow for pricing American-Style options in MF models (Longstaff & Schwartz, 1998)

ŒMost serious impediment for using MF models: choice of correlation matrix between rates

46