INTEREST RATE RISK MANAGEMENT:

DEVELOPMENTS IN INTEREST RATE TERM

STRUCTURE MODELING FOR RISK MANAGEMENT
AND VALUATION OF INTEREST-RATE-DEPENDENT
CASH FLOWS
Andrew Ang* and Michael Sherris†

ABSTRACT
This paper surveys the main concepts and techniques of recent developments in the modeling
of the term structure of interest rates that are used in the risk management and valuation of
interest-rate-dependent cash flows. These developments extend the concepts of immunization
and matching to a stochastic interest rate environment. Such cash flows include the cash flows
on assets such as bonds and mortgage-backed securities as well as those for annuity products,
life insurance products with interest-rate-sensitive withdrawals, accrued liabilities for defined-
benefit pension funds, and property and casualty liability cash flows.

1. INTRODUCTION Boyle (1992), Reitano (1991a, 1991b, 1992, 1993),

The aim of this paper is to discuss recent develop-
ments in interest rate term structure modeling and
the application of these models to the interest rate
risk management and valuation of cash flows that are
dependent on future interest rates. Traditional ap-
proaches to risk management and valuation are based
on the concepts of immunization and matching of
cash flows. These ideas were pioneered in the actu-
arial profession by the British actuary Frank Reding-
ton (1952). Interest rates have long been recognized
as important to the risk management of insurance li-
abilities. Recent developments have incorporated a
stochastic approach to modeling interest rates. A
number of actuaries were early pioneers in this area,
including John Pollard (1971), Phelim Boyle (1976,
1978), and Harry Panjer and David Bellhouse (1980,
1981).
Only a small number of actuaries have been ac-
tively involved in international developments in these
areas over more recent times. These have included
* Andrew Ang is a doctoral student at the Graduate School of Busi-
ness, Stanford University, Stanford, Calif. 94325.
†Michael Sherris, A.S.A., F.I.A., F.I.A.A., is Associate Professor in Ac-
tuarial Studies, School of Economics and Financial Studies, Mac-
quarie University, Sydney, NSW 2109, Australia.
Sharp (1988), Sherris (1994), Shiu (1987, 1988,
1990), and Tilley (1992, 1993), amongst others. Ac-
ademics and practitioners in the finance and invest-
ment area have dominated the theoretical devel-
opments and the practical implementation of the
techniques to financial risk management. In some
ways the actuarial profession has been lucky since it
can draw on a wealth of research ideas in this area.
The formation of the AFIR (Actuarial Approach for
Financial Risks) Section of the International Actuarial
Association has also allowed many of the results of
this research in the financial economics literature to
reach a wider actuarial audience.
Many actuarial problems can use the recent devel-
opments in term structure modeling. These range
across all areas of actuarial practice: life insurance,
general insurance, and superannuation. The stochas-
tic approach to term structure modeling is readily ap-
plied to the interest rate risk management and
valuation of any set of fixed or interest rate dependent
cash flows.
• Annuity Products. Term certain annuities and the
expected cash flows under life annuity products can
be treated as fixed cash flows. Guarantees on the
payments of life annuity products represent a form
of interest rate option. These products require a sto-
chastic approach for risk management and valuation.

1
2 NORTH AMERICAN ACTUARIAL JOURNAL, VOLUME 1, NUMBER 2
• Insurance Products with Interest-Rate-Sensitive
Lapses. Many insurance products have cash flows
that are dependent on future interest rates not only
because their cash flows depend on interest rates
but also because the decrement rates that deter-
mine the timing of payment of the cash flows de-
pend on interest rates. For example, the
withdrawals on an annual premium life product
could increase when interest rates rise.
• Property and Casualty Insurance Company Out-
standing Claims Reserves. The expected claims
payments for general insurance companies are often
treated as risk-free cash flows and are discounted to
present values using risk free rates. To the extent
that the amount or timing of these liability cash
flows depend on interest rates, a stochastic ap-
proach can incorporate interest rate uncertainty in
the valuation.
• Accrued Liabilities of Defined-Benefit Pension
Funds. These liabilities can be treated as expected
future cash flows based on service to date and cur-
rent salary. These cash flows can be valued and ap-
propriate investments selected for them using the
models in this paper.
In many actuarial problems the cash flows depend
on other variables apart from interest rates. For ex-
ample, indexed annuities depend on future inflation,
and claims payments for long-tail liability business for
property and casualty insurance companies also de-
pend on economic inflation. In these cases the ap-
proach in this paper needs to be extended to real
interest rates. This is not covered in this paper, but
there are examples of extensions to the approach cov-
ered in this paper that allow for inflation; see, for ex-
ample, Brown and Schaefer (1994) and Pennachi
(1991).
The techniques in this paper have largely been de-
veloped for asset applications. These range from bond
valuation to complex interest-rate-related securities
such as structured notes.
• Bond Valuation. Fixed-interest securities can be
valued by using a stochastic interest rate model.
The parameters of these stochastic models are
sometimes determined by ‘‘fitting’’ them to traded
bond prices for government securities. These are re-
ferred to as ‘‘arbitrage-free’’ models.
• Interest Rate Options. A stochastic model is re-
quired to value nonfixed cash flows. The basic
traded security that is dependent on future interest
rates is the interest rate option. These instruments
include bond options, options on interest rate fu-
tures, and swaptions.
• Mortgage-Backed Securities. These securities have
cash flows that depend on the history of interest
rates. This is because the cash flows are influenced
by the level of prepayments on the underlying mort-
gages. The amount of these prepayments depends
on the history of interest rates. Where the cash
flows depend on the history of interest rates, the
cash flows are said to be path-dependent. Prepay-
ments can be modeled in a similar manner to dec-
rement rates in insurance products. As an example,
Ang (1994) develops and fits prepayment models us-
ing Australian data.
• Structured Notes. A recent example of innovation
in financial markets is the structured note. This in-
strument is basically a package of a straight bond or
note along with a number of embedded interest rate
options. The embedded interest rate options usually
take the form of caps, floors, or collars.
2. TRADITIONAL APPROACH TO
INTEREST RATE RISK
The traditional approach to interest rate risk manage-
ment and valuation developed and often used by ac-
tuaries assumes a single interest rate. This rate is used
to value cash flows and to determine the sensitivity
of the value of the cash flow to interest rate changes.
This approach is based on the assumption that the
yield curve is flat and interest rates change in a par-
allel and deterministic manner. Historical data indi-
cate that yield curves can take a variety of shapes
including upward sloping, downward sloping (in-
verse), and even humped. This is demonstrated in the
historical data for Australian Government Security
yields from January 1972 to October 1994 presented
in Figure 1. It can also be observed from this data that
yield curve changes are not parallel. It should also be
clear that the process driving interest rate changes is
not deterministic.
2.1 Yield Curves
It is common practice to fit yield curves to market
yields to maturity to describe the relationship be-
tween yields and term to maturity. The actual yields
to maturity are not smooth because of coupon, li-
quidity, and taxation effects. These effects are re-
moved by fitting spot or zero-coupon yields that are
consistent with the yields to maturity. It is best to fit
a curve to the discount function, which is the value
of the zero-coupon bonds for differing maturities,
rather than the spot yields. The discount function
INTEREST RATE RISK MANAGEMENT
FIGURE 1
GRAPH OF AUSTRALIAN GOVERNMENT BOND YIELDS TO MATURITY
curve should be smooth. A number of techniques can
be used to fit these yields. These techniques are sim-
ilar to those used by actuaries in fitting smooth curves
to mortality rates. Two common techniques are the
use of splines and of mathematical formulas:
• Splines. This involves fitting a series of polynomial
curves over the data points, with the points where
the curves join arbitrarily chosen. A specified de-
gree of continuity is imposed on the derivatives. The
abscissa values that define the segments are called
knots. Cubic splines, the most common approach,
use a series of quadratics fitted to the data by least
squares; see Steeley (1991) for an example.
• Formulas. Parameters in a formula may be fitted to
the series of interest rates by using methods such
as least squares and maximum likelihood. Formulas
such as that in Nelson and Siegel (1987) have been
derived with a theoretical justification.
Yield curves can also be fitted directly to spot or
forward rates as well as yields to maturity. The aim
of yield curve fitting is often to derive a zero-coupon
yield curve. Zero-coupon yields can be used to value
any series of cash flows by discounting each cash
flow using the appropriate zero-coupon yield,
whereas yields to maturity and forward rates do not
have such a simple application for valuation of ar-
bitrary fixed cash flows. Yields to maturity are
needed by traders in trying to predict interest rate
movements and bond price variations. Forward in-
terest rates are often more informative for interest
rate futures and options traders. Forward rates are
the basis of the most recent methods developed by
financial economists for constructing stochastic
3
interest rate pricing models as in Heath, Jarrow and
Morton (1990a, 1990b, 1992).
The information contained in the set of current
yields to maturity, spot rates, and forward rates is
equivalent, because they are related by definition.
The discrete time relationships between the forward
rates, spot rates and bond prices are:
P(t, T) 5 [1 1 Y(t, T)]t2T for t , T
P(t, T)
f(t, T, T 1 1) 5 21
P(t, T 1 1)
P (t, T ) 5
1
[1 1 f (t, t, t 1 1)][1 1 f (t, t 1 1, t 1 2)]...[1 1 f (t, T 2 1, T )]
where
P(t, T) 5 the price at time t of a zero-coupon
bond maturing at time T with yield
to maturity Y(t, T) and maturity
(T2t) years
f(t, m, n) 5 the forward rate of interest implied
in the zero-coupon bond yield
curve at time t applying from time
m to time n years, t,m,n
f(t, T, T11) is the one-period forward rate at
time t, applying from time T to
time T11, t,T.
2.2 Arbitrage-Free Conditions
If arbitrage opportunities are not to exist in a deter-
ministic economy, then P(t, T)5P(t, s)P(s, T) for
t,s,T. This is referred to as the principle of no-ar-
bitrate in financial economics. If this condition does
not hold for all s, then it is possible to generate a
dollar at time T at a different cost to the zero-coupon
bond price at time t by rolling over short-term bonds
at the deterministic forward rates.
This result implies that f(s, T, T11)5 f(t, T, T11)
for all s, t≤T. The forward rate applying to a particular
time interval (but not time to maturity) must be con-
stant through time in a deterministic setting if arbi-
trage opportunities are not to exist. The yield curve
does not have to be flat, but the forward rates for any
fixed time interval must be constant through time.
Bond prices will be known but need not be constant,
but they must obey the no-arbitrage condition if mar-
kets are to be in equilibrium. This constant property
of the forward rate curve in a deterministic model is
4 NORTH AMERICAN ACTUARIAL JOURNAL, VOLUME 1, NUMBER 2

one reason why it is often easier to model forward 2.4 Interest Rate Risk Management
rates in a stochastic model. Interest rate risk management in the traditional de-
terministic approach aims to manage variations in as-
2.3 Expectations Hypothesis set and liability values on the assumption that interest
rates undergo small deterministic changes. The orig-
Various theories have been developed to explain the
inal approach developed in the actuarial literature by
relationships between interest rates of varying terms
Redington (1952) effectively assumes that all cash
when interest rates are assumed not known with cer-
flows are fixed and not dependent on interest rates.
tainty. These are based on assumptions about expec-
This excludes any asset or liability for which the tim-
tations of future interest rates in the economy. One
ing or amount of the cash flows depends on the level
version of the expectations hypothesis assumes that
of interest rates. It is also assumed that all cash flows
the expected one-period interest rate is the same for
are valued using the same interest rate. This means
investments of all maturities. There is also a version
that the yield curve is assumed to be flat across all
of the expectations hypothesis in which expected fu-
maturities. Finally, the yield to maturity curve is as-
ture one-period interest rates are equal to the current
sumed to move in a parallel fashion. This approach
implied forward interest rates. In an economy with no
has been expanded to non-flat yield curves (Fisher
uncertainty, this result will hold. Under other theories
and Weil, 1971), to non-parallel shifts in the yield
such as the liquidity premium hypothesis and the pre-
curve (Shiu, 1990), and to allow for stochastic interest
ferred habitat, the expectations hypothesis is modi-
rates and interest-rate-dependent cash flows (Boyle,
fied to include a risk premium that reflects liquidity
1978). It is important to note that a model based on
or maturity preferences in the economy.
parallel yield curve shifts will not be arbitrage-free.
The various forms of the expectations hypothesis
Given that bond prices are convex in their yields, it
are discussed in Ingersoll (1987, Chapter 18). Under
is possible to construct a portfolio of bonds requiring
the local expectations hypothesis, the expected hold-
zero initial investment that will provide a non-nega-
ing period return on bonds of all maturities over the
tive return if all yields change by the same amount.
next time period are assumed to be equal. Thus under
Traditional interest rate risk management uses the
the local expectations hypothesis the expected one-
duration and convexity of cash flows as the main
period return on a bond is equal to the prevailing one
measures of risk.
period spot rate so that:
The use of duration as a measure of the effect of
P(t, T) 5 E[R(t)R(t 1 1) . . . R(T 2 1)]21 interest rate changes on the value of fixed-interest se-
curities originated in the concepts of the average time
R(t) 5 1 1 the one-period spot interest rate at time
to receipt of the cash flows of the security, which was
t, and if continuous compounding is assumed
referred to as ‘‘duration’’ by Macaulay (1938), ‘‘aver-

@
P(t, T) 5 E exp 2 ~ * t
T

!#
r(s)ds
age period’’ by Hicks (1939), ‘‘weighted average time pe-
riod’’ by Samuelson (1945), and the ‘‘mean term of the
value of the cash flows’’ by Redington (1952). The text
where r(s) is the continuous compounding instanta-
by McCutcheon and Scott (1986, page 232) uses the
neous spot interest rate.
terminology ‘‘discounted mean term.’’ Nearly all partic-
Hence under the local expectations hypothesis, all
ipants in financial markets use the term ‘‘duration.’’
bond prices can be derived from the one-period spot
Interest rate risk is traditionally measured by the
rate in discrete time or the instantaneous spot rate in
derivative of the security value with respect to the
continuous time. This rate is referred to as the ‘‘short’’
interest rate. This is based on a first-order approxi-
rate. Similar valuation formulas are derived from sto-
mation to the price change using a Taylor series ex-
chastic term structure models under the assumptions
pansion of the price for a small change in yield around
of no arbitrage between bonds of different maturities.
the current price. Such a definition is readily applied
These models use a ‘‘risk-adjusted’’ short rate in the
to interest rate derivative securities for which the du-
valuation formula for bonds. These results will be re-
ration is not well defined. Minus the first derivative of
viewed under the discussion of stochastic interest rate
the security value with respect to the interest rate as
models.
a proportion of the current value is referred to as the
modified or effective duration of the cash flows.
INTEREST RATE RISK MANAGEMENT
If the Taylor series approximation is taken to sec-
ond derivatives, then the second-order term that re-
sults is referred to as the convexity. The price at yield
to maturity i1, P(i1), can be expressed as a Taylor se-
ries in terms of the price evaluated at the current
yield to maturity i0, P(i0), and the price derivatives as
follows:
(i1 2 i0)
P(i1) 5 P(i0) 1 P' (i0)
1!
(i1 2 i0)2
1 P" (i0) 1 z z z
2!
If the price at i0 is deducted from both sides and both
sides are divided by this price, then we have
P(ii) 2 P(i0) (i 2 i0) P' (i0)
5 1
P(i0) 1! P(i0)
(i1 2 i0)2 P" (i0)
1 1zzz
2! P(i0)
This can be used to develop a second-order approxi-
mation
P(ii) 2 P(i0) (i 2 i0)2
' 2(i1 2 i0) MD 1 1 C
P(i0) 2 applied to select assets with a minimum cost that
where MD is the modified duration of the security and
convexity is defined as
P"(i0)
C5
P(i0)
Another measure of interest rate risk that is often
used in practice is referred to as M2. This terminology
appears to have originated in the paper by Fong and
Vasicek (1984). This measure was called the ‘‘spread’’
of the values of a set of cash flows about the mean
term by Redington (1952). The M2 of a set of asset
cash flows is equivalent to a discounted variance in
the same sense that the duration of a set of cash flows
is the discounted mean term. In fact, the M2 of a set
of asset cash flows can be described as a weighted
variance of time to receipt of the cash flows around
the duration of the cash flows, the weights being the
same as used to calculate the duration.
Modern practice allows for nonparallel yield curve
shifts in the deterministic model using the concepts
of multivariate duration and convexity analyzed by
Reitano (1991a, 1991b, 1992a, 1992b). These multi-
variate duration measures are similar to the key rate
durations of Ho (1992). The term structure is divided
into separate maturity ranges sometimes referred to
as ‘‘buckets.’’ The sensitivity of values is determined
5
separately for changes in the yield curve in each
bucket and all other buckets remain unchanged.
These approaches give no recognition to the correla-
tion structure of yield curve changes across the ma-
turity spectrum. To do this requires a stochastic
model. These deterministic multivariate approaches
are not arbitrage-free as Shiu points out in his dis-
cussion of Reitano (1992b).
The concepts underlying immunization in a deter-
ministic model extend to a stochastic multifactor in-
terest rate model. An example is Jarrow and Turnbull
(1994).
2.5 Matching and Optimisation
Portfolios of bonds that match a specific set of liabil-
ities can be selected by using linear programming
(Shiu 1988; Kocherlakota, Rosenbloom and Shiu
1988, 1990). The matched portfolio of bonds is cho-
sen to minimize the cost of the bond portfolio such
that the asset cash flows can always meet the liability
cash flows. A carry-forward of positive cash balances
from an excess of asset cash flows over liability cash
flows can be included. This methodology can also be
have a duration that matches the liability cash flows.
The portfolio of bonds can also be selected by min-
imizing the risk (M2) of the difference between the
asset and liability cash flows subject to the constraint
that the present value of the bonds equals the present
value of the liabilities and the duration of the bonds
equals the duration of the liabilities. This approach
requires the spread of asset cash flows to exceed the
spread of the liability cash flows and no options in the
cash flows (Shiu 1990). Once again this approach ex-
tends naturally to a multifactor stochastic interest
rate model. In the stochastic case the sensitivities to
the random factors are matched for the assets and
liabilities.
Introducing risk requires an approach similar to the
portfolio selection problem for any investor. The re-
lation between matching of cash flows and portfolio
selection models is discussed in Sherris (1992). Port-
folio selection models often use quadratic program-
ming to select assets that minimize the variance of
surplus, defined as the accumulated excess of asset
cash flows over liability cash flows, for a given ex-
pected value of surplus on a terminal date. This ap-
proach to matching and portfolio selection for
interest-sensitive cash flows uses a stochastic model
for interest rates.
6 NORTH AMERICAN ACTUARIAL JOURNAL, VOLUME 1, NUMBER 2
3. STOCHASTIC TERM STRUCTURE
MODELS
Most actuaries would be unfamiliar with models, such
as Ho and Lee; Hull and White; Black, Derman, and
Toy (BDT); and Heath, Jarrow, and Morton (HJM),
that are commonly used by brokers and investment
banks as the basis for the interest rate risk manage-
ment of their bond and interest rate option portfolios.
These models use a stochastic approach to term
structure modeling.
An early example of the stochastic approach to in-
terest rate risk management is found in the prize-win-
ning paper by Boyle (1978). The stochastic approach
has seen rapid development in recent years probably
because of the increase in volatility of interest rates,
but a major factor would be the significant increase
in desktop computing power. The techniques used are
the same as those underlying option-pricing. Term
structure models and option-pricing models are ex-
amples of a more general contingent claims pricing
technique.
Early models used an equilibrium asset pricing ap-
proach to determining bond prices. More recently, the
arbitrage-free approach has found more favor. The
more recent approach to term structure models is
based on martingale methods. For further references,
readers are directed to the following recently pub-
lished books. Jarrow (1996) covers interest rate mod-
els in the HJM framework mostly in a discrete time
setting. Jarrow and Turnbull (1996) and Ritchken
(1996) are recent textbooks that contain an excellent
coverage of the modern approach to interest rate de-
rivative valuation. For a comprehensive coverage of
the theoretical tools and the various models used in
stochastic term structure models, readers are referred
to Rebonato (1996).
3.1 General Contingent Claims Pricing
In contingent claims pricing stochastic models were
initially developed in continuous time by deriving a
stochastic partial differential equation to represent
changes in the random factors, or state variables,
driving the model, or in discrete time by stochastic
difference equations. In continuous time the factor is
assumed to follow a diffusion process. For a factor X
the form of such a process for the instantaneous
change in X is:
dX 5 µ(X,t)dt 1 s(X,t)dZ
where dZ is the increment in a standard Wiener pro-
cess.
The term µ(X,t) is called the drift, and s(X,t) is the
diffusion term, which is also often referred to as the
volatility. The drift represents the expected change in
the series and the diffusion provides the random
change.
In discrete time the process is usually approxi-
mated using the first-order Euler approximation:
X(t 1 Dt) 2 X(t) 5 µ(X,t)Dt 1 s(X,t)=Dtε t
where εt;N(0,1). Higher-order approximation methods
have been developed (Kloeden and Platen 1992).
Some commonly used forms of these processes as-
sume that the difference in the variable X is station-
ary. Such a process is said to have a ‘‘unit root’’ and
be difference stationary. Other commonly used forms
of these processes assume that the variable X itself is
stationary as in the ‘‘mean-reverting’’ models used for
interest rates.
The result required from contingent claims pricing
in term structure modeling is the partial differential
equation for security values assuming that markets
are complete and arbitrage-free. If V(X, t) denotes the
value of a security that is a function of X and t, then
the partial differential equation (pde) that must be
satisfied by V is:
VX[µ(X,t) 2 l (X,t)s(X,t)]
1
1 V s2(X,t) 1 Vt 5 r(t)V
2 XX
where subscripts indicate partial derivatives and
l(X, t) is referred to as the market price of risk. The
result is developed in standard texts such as Duffie
(1992), Hull (1993) and Shimko (1992). This equa-
tion is also derived in Appendix A. Note that unless X
is a traded asset, then the market price of risk cannot
be eliminated. This is especially important for pricing
interest-rate-dependent claims because interest rates
themselves are not traded assets.
The terms in this pde have a natural interpretation.
The left-hand side gives the (risk-adjusted) expected
change in the security value. The first term is the sen-
sitivity of the security’s value to small changes in the
random factor X times the (risk-adjusted) expected
change in X. The next term is a second-order term
similar to the convexity term in the deterministic
model. The third term is the change in the value that
results from small changes in time. The right-hand
side is equal to the risk-free rate times the value of
the security. Hence, the pde simply states that in a
INTEREST RATE RISK MANAGEMENT
risk-adjusted arbitrage-free stochastic pricing model,
the expected return on the security is the instanta-
neous risk-free rate.
The solution to the pde depends on the particular
security to be valued, since this will determine the
relevant boundary conditions. The absence of arbi-
trage can be shown to be (essentially) equivalent to
values being discounted expected values with respect
to a risk-neutral probability distribution referred to as
an equivalent martingale measure. Shiu (1993, Sec-
tion 4) provides a concise discussion of this result for
the finite discrete time case. The continuous time
case is very complex and is covered in Delbaen and
Schachermayer (1994). Under these assumptions the
value of all securities expressed in units of a money
market account earning the instantaneous risk free
rate is a martingale. The solution to the pde, where it
can be determined analytically, can be shown to take
the form of a (risk adjusted) discounted expected
value of the cash flows with respect to the equivalent
martingale measure (Duffie, 1992).
3.2 Interest-Rate-Dependent Security
Pricing
The earliest approach to term structure modeling was
to take the instantaneous spot rate, referred to as the
‘‘short rate’’ or ‘‘the’’ spot rate, as the random factor
in a continuous time model. This short rate is usually
defined as the continuous time equivalent of the one-
period spot rate in a discrete model. Assume that r
follows the diffusion
dr 5 µ(r,t)dt 1 s(r,t)dZ
The value of an interest-rate-dependent security
P5P(r, t) that is assumed to be a function of the single
factor r is given by the pde:
1
P s(r,t)2 1 Pr µ* 1 Pt 5 rP
2 rr
The terms in this pde have an intuitive interpretation.
This is clearer if it is rewritten in terms of the secu-
rity’s effective duration and convexity as follows:
1 d50
PCs(r,t)2 1 2P(MD)µ* 1 Pt 5 rP
2
The left-hand side is the (risk-adjusted) expected re-
turn on the security that results from an application
of Itô’s lemma and an arbitrage-free assumption. The
first term is a function of the security’s convexity and
the volatility of the short interest rate. The second
term is the expected change in the security value for
7
a small change in the ‘‘short’’ interest rate times the
expected change in the short rate, and the third term
captures the change in value with time. The right-
hand side is the risk-free return on the security.
Hence the pde states that, on the assumptions that, if
markets are complete and arbitrage-free, the short
rate follows a diffusion and the security’s value is a
function of the short rate, then the (risk-adjusted) in-
stantaneous return on the bond is equal to the risk-
free rate.
The term structure is determined by the zero-cou-
pon bond prices since these give the spot rates for
varying maturities. The pde can be solved for zero-
coupon bond prices by specifying the process for the
short rate and the boundary conditions for the zero-
coupon bond. In the case of the zero-coupon bond,
the boundary condition is that the value P(r, T)51 on
the maturity date (T) of the bond. For specific forms
of the diffusion for r, an analytical solution for zero-
coupon bond prices exists and takes the form:
P(r,t) 5 A(t,T)e B (t,T)r
where A(t, T) and B(t, T) depend only on time and
the maturity of the bond and r is the current short
rate. The exact form of the parameters A and B for
different models can be found in the original papers
or in Duffie (1992), Hull (1993), and Hull and White
(1994).
This zero-coupon bond formula applies for the
affine class of parameter specifications with
µ(r, t) 5 a 1 br
and
s(r, t) 5 =c 1 dr
in the diffusion for the short rate. In this case, A(t,T)
and B(t,T) depend only on the time to maturity (T2t).
More details are provided in Duffie (1992, pages 133–
136), Rebonato (1996, Chapter 15), and Wilmott,
Dewynne, and Howison (1993, Chapter 14). Vetzal
(1994) provides a comprehensive survey of continu-
ous time models. Specific cases of this form of the
diffusion are:
gives the Vasicek (1977) model
where dr5(a1br)dt1sdZ. In this
case the volatility s(r, t)5=c5s is
constant and deterministic and the
drift term allows for mean reversion
of the short rate.
8 NORTH AMERICAN ACTUARIAL JOURNAL, VOLUME 1, NUMBER 2
c50 gives the Cox, Ingersoll, and Ross
(1985) model dr5(a1br)dt1s=r dZ
with s(r, t)5=dr5s=r. This is the
square root model with stochastic
volatility depending on r.
b50 and d50 give a Gaussian-path-independent
model (see Jamshidian, 1991a)
since the drift and volatility do not
depend on the short rate r.
All these cases assume no time dependence in the
short-rate parameters. If the volatility is a determin-
istic function, then the short rate will have a Gaussian
distribution.
The parameters can be assumed to be time depen-
dent so that
µ(r,t) 5 a(t) 1 b(t)r
and
s(r,t) 5 =c(t) 1 d(t)r.
One example is b(t)50, c(t)5c and d(t)50, which
gives the continuous time equivalent of the Ho and
Lee (1986) model dr5a(t)dt1sdZ. This model has a
deterministic and time varying drift and constant vol-
atility for the short rate. Another example is d(t)50,
which gives the general Gaussian model with time-
dependent parameters as analysed by Jamshidian
(1990), so that dr5(a(t)1b(t)r)dt1s(t)dZ. In this
model the forward rate volatilities decline exponen-
tially as the forward date increases.
Other cases often do not permit an analytical so-
lution, so that numerical techniques are required. The
continuous time equivalent of the BDT (1990) model
given by
d log(r) 5 @
a(t) 1
s(t)
s(t) #
log(r) dt 1 s(t)dZ
is an example. In this case the short rate is lognormal.
If it is assumed that the volatility s(t) is constant,
then s(t)50 and the model becomes a lognormal
version of Ho and Lee.
In the case of lognormal models it is better to model
the nominal or effective interest rate rather than the
continuously compounding short rate with a diffusion.
The reason for this is that it can be shown that ex-
pected accumulation factors over fixed future time in-
tervals in a lognormal model for the continuously
compounded rate are unbounded, as shown by Hogan
and Wientraub (1993). This problem does not occur
if the interest rate modeled is a nominal rate with a
compounding frequency such as monthly, half-yearly
or annually. Such a model in a discrete implementa-
tion is found in Sandmann and Sondermann (1993)
and in Sherris (1994).
As the number of parameters in the short-rate pro-
cess is increased, either by adding additional param-
eters or by making them time-dependent, more input
parameters can be used to specify the models.
The solution to the pde for the value of a zero-cou-
pon bond can in general be written in the form of an
expectation. This expectation takes the form:
$* %
T
P(r,t,T) 5 E* exp 2 r(s)ds
t
where the * denotes an expectation with the drift
term for the diffusion for r adjusted from µ(r, t) to
µ(r, t)2l(r, t)s(r, t). This adjusted diffusion is re-
ferred to as an equivalent martingale measure. Deri-
vation of this result can be found in many papers and
texts. It is the Feynman-Kac solution to the pde. The
interested reader is referred to Duffie (1992, p. 86).
This result extends to other interest-rate-dependent
cash flows such as those for interest rate options. The
value of a security with interest-rate-dependent payoff
of C(r, T) at time T is given by
$* %
T
C(r,t,T) 5 E*[exp 2 r(s)ds C(r,T)]
t
It is not correct to simply discount the expected pay-
offs from a security at the prevailing spot rate. The
risk-adjusted rate must be used where the expected
growth rate in each variable is reduced by the product
of the market price of its risk and its volatility. The
form of this expectation is identical to that derived
under the local expectations hypothesis. The local ex-
pectations hypothesis assumes the role of risk-neutral
pricing, and the results imply we can obtain a secu-
rity’s value by taking an expected value and discount-
ing at the risk-adjusted short rate. In more complex
cases simulation can be used to obtain this expected
value.
If the value of a money market account at time t
accumulating at the instantaneous risk-free rate from
time 0 is denoted by M(t), then
$* %
t
M(t) 5 exp r(s)ds .
0
The value of the interest-rate-contingent claim can
then be rewritten as
INTEREST RATE RISK MANAGEMENT 9

C(r,t,T)
M(t)
5 E* @
C(r,T)
M(T)
. # A binomial lattice can also be derived, but this is a
little more tricky, requiring a change of variable in the
pde. Once again a full derivation is presented in Ap-
So that the expected value of the payoff on the se- pendix C. The binomial lattice takes the form
curity in units of the money market account is equal
to the current value of the security divided by the
current value of the money market account. This P(i+1)
martingale result is fundamental to arbitrage-free
pricing and holds if markets are arbitrage-free. If mar-
kets are complete, then the adjusted diffusion, re-
P(i)
ferred to as the equivalent martingale measure, is
unique.
1–
3.3 Lattice Models P(i–1)

These continuous time models are implemented in a time j time j+1

discrete form in practice by using a lattice of values.
Lattices actually arise from finite difference approxi-
mations to the fundamental pde for pricing securities.
Such discrete models are in fact equivalent to the
continuous time stochastic approaches. The lattice
approach to the numerical solution to the pde is to
project the values of the factor X on lattices. In this
way the diffusion term in the stochastic equations for
the factors can be represented by the spread of the
factor values on the lattice at each point. Branches of
a tree are not restricted to being binomial: Hull and
White (1993a) use trinomial trees and Bookstaber, Ja-
cob, and Langsam (1986) describe the relationship bi-
nomial trees must have with multinomial trees for
no-arbitrage relationships to hold. Similarly, any
strategy employed on a discrete lattice can also be
employed in a continuous time framework with the
right restrictions and the corresponding algorithm.
A trinomial lattice can be obtained by substituting
appropriate finite difference approximations to the
partial differentials in this pde. Details are provided
in Appendix C. The result is a lattice as follows:
P(i+1)
a*
b*
P(i) P(i)
c*
P(i–1)
time j time j+1
where a*, b*, and c* are referred to as risk-neutral
probabilities.
where the p is the risk-neutral probability of the up
jump.
The lattice that results from the discretization of
the pde is in terms of the bond price, P. In discrete
interest rate models, it is usually the one-period spot
interest rate, or ‘‘short’’ rate, that is modeled on a
lattice. In fact, it is common to model interest rates
rather than bond prices, since these are often consid-
ered to be the natural state variable in an interest-
rate-dependent security valuation model. However,
since it is assumed that the bond price is a function
of the interest rate, there is a one-to-one correspon-
dence between bond prices and this interest rate. It
could be argued that since bonds trade and prices are
observable, at least for traded maturities, that bond
prices are a more appropriate state variable to use.
3.4 (Partial) Equilibrium Models
Various approaches have been taken by researchers
in developing term structure models that involve
making different assumptions about the market price
of risk l(r, t). Equilibrium approaches involve making
some assumptions about the risk preferences of in-
vestors to specify the form for the market price of
risk. Taking the interest rate as the state variable re-
sults in preference-dependent bond prices because
rates of interest are nontraded assets. In contrast, ar-
bitrage-free models fit the market price of risk to cur-
rent bond prices directly.
Equilibrium models rely on assumptions about the
structure of capital markets and the preferences of
investors. If investors’ utility functions are logarith-
mic, then the market price of risk is constant (Dothan
1978, pp. 61–62). Vasicek (1977) derives bond-pricing
10
solutions for a constant price of risk in his model.
Longstaff (1990), Courtadon (1982), and Dothan
(1978) are examples of equilibrium approaches that
assume log utility and specify the market price of risk
as a constant. Rendelman and Bartter (1980), in one
of the first discrete models for bond prices, also as-
sume logarithmic utility. Cox, Ingersoll, and Ross
(1985), in a major contribution to equilibrium asset
pricing and term structure modeling, assume the mar-
ket price of risk is a function of the interest rate and
assume constant relative risk aversion utility func-
tions. They also show the importance of consistency
between assumptions for the utility function and the
functional form of the market price of risk.
Equilibrium models can incorporate different sto-
chastic processes for the instantaneous spot interest
rate. These may have drifts that are mean-reverting
or linear, and the diffusion may be constant or depend
on the level of the factor. With constant prices of risk,
these models are able to yield closed-form solutions
that is, analytical bond pricing formulas for the term
structure. Such formulas allow direct calculation of
bond prices, and prices of bond options, without the
use of a numerical technique.
Multiple factors can be incorporated in equilibrium
models. Brennan and Schwartz (1979) specify sepa-
rate correlated processes for the long and short rates.
Using arbitrage arguments, Brennan and Schwartz are
able to eliminate the market price of risk term for the
long rate, so that in their two-factor model there is
only one market price of risk, which is assumed to be
constant. A similar model is Schaefer and Schwartz
(1984), which instead uses the short rate and the dif-
ference between the long rate and short rate. Longs-
taff and Schwartz (1992) develop a two-factor model
with stochastic volatility as one of the factors.
Multiple factor models are important for actuaries
who want to value products with multiple random fac-
tors affecting their value (for example, mortality, in-
terest rates, withdrawals, and so on). One example
with constant prices of risk for each decrement factor
for pricing life insurance products involving mortality
and withdrawal risk is Manistre (1990).
Equilibrium models are said to endogenize the term
structure. The price of risk must be estimated from
bond prices. Rarely will an equilibrium approach gen-
erate zero-coupon bond prices that are consistent with
the market prices of all zero-coupon bonds, whatever
the specification of the market price of risk. The fit will
usually be only approximate. In contrast, the arbitrage-
free approach produces model prices that exactly fit
the observed prices of zero-coupon bonds.
NORTH AMERICAN ACTUARIAL JOURNAL, VOLUME 1, NUMBER 2
Arbitrage-free approaches have gained favor be-
cause in pricing derivative securities on term struc-
ture instruments, they ensure that the model at least
prices the underlying term structure correctly. As
Hull (1993) notes, traders have little confidence in
models that generate bond prices dissimilar to the ob-
served bond prices in the market. Arbitrage-free ap-
proaches use algorithms that choose the parameters
of the model such that the prices of the zero-coupon
bonds that are derived using the algorithm are equal
to the market prices of the bonds on the valuation
date.
3.5 Arbitrage-Free Models
Arbitrage-free models are in many ways similar to the
equilibrium approaches. In equilibrium approaches
the market price of risk is specified. In an arbitrage-
free approach the market price of risk is taken to be
that observed in the market. Like equilibrium models,
analytical solutions are available for some models,
and both approaches can be implemented by discrete
methods or by simulation. Models can have as many
parameters as necessary to fit the observed term
structure and volatilities. Heath, Jarrow, and Morton
(1992) have developed a multifactor arbitrage-free
model that will fit any term and volatility structure.
However, despite their current popularity, arbitrage-
free approaches are not the panacea for term struc-
ture modeling for the following reasons:
• Arbitrage-free models involve estimating the param-
eters of prespecified models. They tell us nothing
about the adequacy of the model itself. For example,
most Gaussian arbitrage-free approaches permit
negative interest rates. As Marsh (1994) notes, this
is an important consideration in the design phase of
any model, be it equilibrium or arbitrage-free.
• Arbitrage-free models price according to the term
structure. This does not allow us to identify arbi-
trage opportunities on the yield curve itself like
yield curve shifts. If the present yield curve has ar-
bitrage opportunities, then our model also has those
same inconsistent arbitrage opportunities. Using an
equilibrium model, if the model is right, allows us
to trade bonds at a profit if the market prices are
not equal to the model prices. Such arbitrage is not
possible with an arbitrage-free approach.
• The choice of parameters and their subsequent be-
havior often restrict the dynamics of the change in
the yield curve through time. For example, the con-
stant volatility in the Ho and Lee (1986) model is
the same for both the spot and forward rates, and
INTEREST RATE RISK MANAGEMENT
the Pederson, Shiu, and Thorlacius (1989) model
assumes that volatility declines with time. These be-
haviors of the dynamics of the yield curve may not
fit the actual dynamics of the yield curve, and the
choice of model itself is then inappropriate.
• Models are usually built around key rates being ar-
bitrage-free (for example, cash, 30-day, 90-day, 1-
year, 2-year, 5-year, 10-year yields), so that the in-
terim rates may well have arbitrage opportunities.
These approaches may be inconsistent in the sense
of Bookstaber, Jacob, and Langsam (1986), since
the full span of rates is not being considered and
the prices obtained on such a model could be un-
reliable.
• Most arbitrage-free approaches fit the model param-
eters to the zero-coupon bond yield curve. There is
no theoretical reason to use the spot rate yield
curve. The parameters of the model could just as
easily be fitted to other traded instruments. Fitting
to one set of securities also does not allow us to
identify arbitrage opportunities with other securi-
ties. Some practitioners and researchers use a range
of instruments including caps and floors to fit the
model parameters. The aim of fitting the model is
to determine the state-contingent security prices
(Arrow-Debreu securities), since these can be used
to price any security using the model. For this rea-
son the model is likely to be more reliable if it uses
actively traded interest rate options to fit param-
eters, since these are closer in payoff to the state-
contingent securities than the zero coupon bonds.
3.6 Black-Scholes Interest Rate Option-
Pricing
The pde for equilibrium and arbitrage-free models can
be solved for bond and interest rate option prices. Un-
der the assumption that the short rate is Gaussian,
bond prices are lognormal and analytical formulas can
be derived. Under this assumption zero-coupon bond
and interest rate options are valued using a formula
similar to the Black-Scholes equity option formula
modified to allow for stochastic interest rates. The
volatility assumption for equities is replaced with a
term structure of volatilities for forward interest rates.
These analytical formulas can also allow for mean re-
version in interest rates.
The Black-Scholes formula can be applied to op-
tions on zero-coupon bonds. However, the application
11
to coupon-paying bonds is not as straightforward. In
a single-factor model a form of the Black-Scholes
formula can be used for options on coupon-paying
bonds. Jamshidian (1991a) demonstrates the tech-
nique required and proves the results. Hull and White
(1993b) develop results for the case in which short-
rate volatilities are deterministic.
The other problem with Black-Scholes is that it can
not be used directly for American options (with early
exercise). Since many traded options are American
style, this is a significant practical problem. Discrete
numerical methods of valuing interest rate options
can readily allow for early exercise. The Black-Scho-
les formula does not allow for path-dependent options
such as options on the average of interest rates (Asian
options).
The Gaussian assumption for interest rates is often
not satisfactory, since negative spot and forward in-
terest rates are possible in such models. More realistic
models can be used, but this requires the use of dis-
crete numerical approaches to determining values.
With developments in computational techniques and
significant increases in computing speed, this is not a
significant problem.
3.7 Discrete Time Methods
The discrete implementation of equilibrium and ar-
bitrage-free models is usually done on lattices. Inter-
est rates are usually projected on recombining trees
for computational reasons. Tree modeling has its or-
igins in the classic stock option-pricing approach of
Cox, Ross, and Rubinstein (1979). Jarrow (1996) pro-
vides a comprehensive development of discrete time
term structure modeling and valuation of interest rate
derivatives.
Arbitrage-free models require the fitting of the
model parameters to the yield curve before they can
be used for valuation. Valuation of interest-rate-de-
pendent securities is carried out by using arbitrage-
free paths of the short interest rate. This is done using
forward induction. Valuation (pricing) is then done
using backward induction. Since the principles are
the same for both equilibrium and arbitrage-free mod-
els, this paper concentrates on arbitrage-free models.
In a discrete binomial model the paths of interest
rates are determined by three parameters which are
fitted to the market data to ensure that the model is
arbitrage-free. These are the size of the up jump, the
size of the down jump and the probabilities of the up
12
jump for each time interval and next period interest
rate:
ru
r0
1–
rd
The value of a bond is calculated by backward induc-
tion or recursion through the tree. The algorithm can
most generally be specified in terms of Arrow-Debreu
prices, also referred to as state-contingent prices,
G(n, i, m, j), which are the prices of a security at time
n and state i, which pays $1 at time m, m.n, and
state j and $0 elsewhere. The state of the model de-
termines the value of the interest rate.
Arrow-Debreu securities are the ‘‘primitive’’ state-
contingent securities in the model because the payoff
structure for any state-contingent security can be rep-
licated by a portfolio of appropriate Arrow-Debreu se-
curities. The sum of the values of the appropriate set
of Arrow-Debreu securities is the value of the state-
contingent security. These Arrow-Debreu securities
are the discrete equivalent of Green’s function, which
is the fundamental solution to the pde of any security
value (Jamshidian 1991b).
The general backward induction valuation algo-
rithm for state contingent security prices can be writ-
ten as:
G(n,i,m,j) 5
p(n, i)G(n 1 1, i 1 1, m, j) 1 (1 2 p (n, i))G(n 1 1, i 2 1, m, j)
1 1 r(n, i)
where p(n,i) is the probability of going to state i11
from state i at time n, and r(n, i) is the one-period
prevailing interest rate at state i at time n. Note that
the equation above relates the value of the Arrow-De-
breu securities at the two nodes at time n11 to the
value of the Arrow-Debreu security at the node at
time n. The value at time 0 of a security paying C(m,
j)51 at time m for all states j, by definition the m
maturity zero-coupon bond, can be written as:
ZCB(0, m) 5 Σ
all states j
G(0, 0, m, j)C(m, j)
Note that the movements in interest rates and the
Arrow-Debreu prices are path-independent. That is,
G(n, i, m, j) has the same value irrespective of the
NORTH AMERICAN ACTUARIAL JOURNAL, VOLUME 1, NUMBER 2
path taken to state i at time n and the path taken to
state j at time m. Path-dependent valuation is
implemented using path wise valuation in a similar
manner. This valuation formula is also used to deter-
mine the value of zero-coupon bonds on future dates
for future states. At each node in the lattice a vector
of zero-coupon bond prices for future maturities is
determined from this formula.
3.8 Discrete Time Models
In a binomial model there are three degrees of free-
dom at each node available to fit three different
parameters. In a single-factor short-rate model of the
term structure, the degrees of freedom can be used to
fit the market prices of risk, a volatility structure for
the short rate, and a volatility structure for forward
rates.
Kalotay, Williams, and Fabozzi (1993) develop a
lognormal model of interest rates in which the spot
rates are constrained to be positive. They fit a single
degree of freedom in the down jump and fix the prob-
abilities at a half. The KWF approach is fast and com-
putationally easy. The model does not fit an explicit
volatility structure.
Methods involving two degrees of freedom can be
subdivided into those dealing with the down jump and
the difference between the down and up jump, and
those dealing with the down jump and the probability
of the up jump. With two parameters, an arbitrary
prescribed initial volatility curve can be incorporated.
The BDT model (1990) is an implementation involv-
ing rd and ru2rd: it has mean-reversion in the short
rate and imposes a volatility structure at each future
epoch. In fact, Jamshidian (1991b) shows that the
BDT forecasts an increasing short-rate volatility to
accommodate a flat current volatility curve.
Another model involving two degrees of freedom is
Ho and Lee (1986), who were the first to propose an
arbitrage-free model. Ho and Lee can be implemented
by choosing two degrees of freedom, the probability
p and the down jump rd. As noted earlier, the Ho and
Lee model has an analytic solution since its contin-
uous time limit is an additive normal model for the
short rate of the form dr5a(t)dt1sdZ with
a(t)5Ft(0,t)1s2t, where Ft(0, t) is the derivative with
respect to t of the instantaneous forward rate applying
to time t at the initial date of the yield curve used to
fit the parameters (time 0). This implies that all spot
and forward rates have the same volatility. Since this
is a Gaussian model, negative short rates are possible.
INTEREST RATE RISK MANAGEMENT
Methods employing three degrees of freedom, p, rd,
ru at each time and state, lead to a non-recombining
tree. Such an implementation could be used to value
path-dependent securities for which the value of the
security depends on the past behavior of the short
rate r. The problem with using non-recombining trees
is that they are computationally intensive. Such a lat-
tice can be used to model a one-factor Heath, Jarrow,
and Morton (1992) model. Simulation is often used
instead of lattice approaches for path-dependent val-
uation.
3.9 Model Fitting—Forward Induction
Forward induction is an efficient technique used to fit
the parameters in an arbitrage-free model. Backward
induction, as previously described, is used to obtain
the value of the cash flows, working backwards in
time calculating expected values and discounting. In
contrast, forward induction involves working forward
in time from the current date. The relationship be-
tween forward and backward induction is seen in the
fundamental pde introduced earlier. In continuous
time, a Green’s function, the fundamental solution of
pde’s, satisfies two fundamental differential equations:
the Kolmogorov backward equation and the Kolmo-
gorov forward, or the Fokker-Planck, equation (Duffie
1992).
The backward equation is the pde introduced ear-
lier, which can be rewritten as:
1
gt 1 gx µ(x,t) 1 g s2(x,t) 2 r(x,t)g 5 0
2 xx
where µ(x,t) and s2(x,t) are the drift and volatility
terms, respectively, of the process for x. The Fokker-
Planck equation is given by:
1
2gt 2 gx µ(x,t) 1 g s2(x,t) 2 r(x,t)g 5 0
2 xx
In discrete time, the corresponding formulations are
forward and backward induction. The forward induc-
tion relationship actually arises by substituting back-
ward finite differences in the Kolmogorov forward
equation and working through the equations in Ap-
pendix C. An insight into the relationships between
the two can be considered by a reexamination of the
binomialization of the continuous processes. Forward
induction gives a relationship between two values of
the security at t and one value at t11, and backward
induction gives a relationship between two values of
the security at t11 and one value at t. This is illus-
trated in the following diagram. In the diagram G(i)
13
represents the value of a primitive security, or
Green’s function, that satisfies the pde.
G(i+1) G(i+1)
G(i) G(i)
1– 1–
G(i–1) G(i–1)
time t time t+1 time t time t+1
Backward Forward
Induction Induction
Backward induction is used by discrete pricing mod-
els to work backwards through a tree to obtain the
price of a security by placing known payoffs at the
terminal branches of the tree. To value a zero-coupon
bond with maturity T, payoffs of $1 are placed at the
terminal branches at time T and backward induction
is used to value these back to time 0. In an arbitrage-
free discrete model, the parameters at time T are de-
termined by making sure the model values the T
maturity zero correctly. A naive approach to fitting
these parameters will generally involve significant
computation if backward induction is used to calcu-
late model prices for all the zero-coupon bonds in
order to fit the short rate parameters to market prices.
Jamshidian (1991b) uses forward induction to dra-
matically cut the computation required to fit the yield
curve. He uses forward induction to fit the parameters
of his model to the yield curve. Consider a model with
one parameter, the down jump, with the difference
between the down and up jump predetermined so the
tree recombines. The probabilities of the jumps are
fixed at 1/2. The backward equation in terms of state
contingent prices is:
G(n, i, m, j) 5
@ #
1 G(n, i, m, j 2 1) 1 G(n 1 1, i 2 1, m, j)
2 1 1 r(n, i)
The corresponding binomial forward equation has its
discounting done at the two previous nodes:
@
1 G(n, i, m, j 2 1)
G(n, i, m 1 1, j) 5
2 1 1 r(m, j 2 1)
1
G(n, i, m, j 1 1)
1 1 r(m, j 1 1) #
14
This formula uses discount factors that push forward
from the last nodes of the tree. This gives a technique
for working prospectively, rather than retrospectively.
Having fitted the parameters so that the T maturity
zero-coupon bond is priced correctly, forward induc-
tion is used to ensure the T11 maturity zero-coupon
bond is priced correctly without having to work back-
wards through the tree.
Sherris (1994) gives a practical example with de-
tailed numerical implementation of the principles of
Jamshidian’s (1991b) forward induction. A simple ex-
ample of this approach is also given in Chapter 9 of
Sherris (1996). Both authors consider fitting the drift
over time to match the given term structure using log-
normal or normal models with initial spot rate vola-
tilities defined for each period.
Forward and backward induction can also be used
when simulation is used, as discussed in Tilley (1992).
Consider the case in which a number of paths of short
rates up to time T have been generated. The T ma-
turity zero-coupon bond is valued by discounting
along each path the value of $1 at time T. This is
backward induction. If these paths of interest rates up
to time T generate the market value of zero-coupon
bonds for maturities t51, 2, . . . , T, then the model is
arbitrage-free up to time T. Forward induction can be
used to fit the parameters for calculating the value of
the T11 maturity zero once the price of the T ma-
turity zero is known. With one degree of freedom (the
drift term), simply alter the model’s drift until the
T11 maturity zero price calculated from the model
equals the observed market price.
With two degrees of freedom (the drift and volatility
terms), simply alter the model’s drift and volatility un-
til the T11 maturity zero price calculated from the
model equals the observed market price and the
model standard deviation of the T11 maturity zero is
equal to the required historical or implied volatility.
This algorithm can be used with simulation to estab-
lish the probability distribution of paths in the risk-
neutral world. Ang (1994) uses the techniques of both
forward and backward induction, along with simula-
tion, to value mortgage-backed securities in a model
incorporating variance reduction techniques.
3.10 Forward Yield Curve Models—HJM
Heath, Jarrow, and Morton (1992) developed a gen-
eral multifactor framework for term structure mod-
eling using the entire forward yield curve and its
arbitrage-free evolution rather than the ‘‘short’’ rate.
They recognize the relationship that must hold
NORTH AMERICAN ACTUARIAL JOURNAL, VOLUME 1, NUMBER 2
between the evolution of the instantaneous returns on
bonds, the spot rates, and the forward rates and show
that in an arbitrage-free model the evolution of the
yield curve is determined by the initial forward yield
curve and the forward rate curve volatility structure.
Single-factor spot rate models are Markov in the short
rate. These models are special cases of the HJM
framework.
In general, the HJM approach leads to path depend-
encies in the evolution of the ‘‘short’’ rate over time.
Careful development and implementation of HJM
models can provide Markov non-path-dependent mod-
els. Brace and Musiela (1994) develop a model based
on HJM that is Markov in the forward yield curve.
To show the relationship between the evolution of
bond prices, forward rates, and spot rates, consider
the continuous equivalents for the definitions of spot
rates, forward rates, bond prices, and yields for the
discrete formulas. These are:
P(t, T) 5 exp[2Y(t, T)(T 2 t)]
] ln P(t, T)
f(t, T) 5 2
]T
$* %
T
P(t, T) 5 exp 2 f(t, s) ds
t
Let P(t, T) denote the price at time t of a T-maturity
zero-coupon bond with the instantaneous return on
this bond assumed to follow the stochastic partial
differential equation (diffusion):
dP(t, T)
5 µP (t, T)dt 2 sP (t, T)dz(t).
P(t, T)
The instantaneous forward rates at time t applying
from time T to T1dT follow a diffusion of the form
df(t, T) 5 µ f (t, T)dt 1 sf (t, T)dz(t).
Since the forward rates and bond prices are related
by the definition
] ln P(t, T)
f(t, T) 5 2
]T
Itô’s lemma gives the relationships that must hold be-
tween the drift and volatility of the instantaneous re-
turn on the T maturity bond and the forward rates.
These are
]
µ (t, T) 5 2 µ f (t, T) 1 sP(t, T)s f (t, T )
]T P
INTEREST RATE RISK MANAGEMENT
and
]
s (t, T) 5 s f (t, T)
]T P
so that
T
sP(t, T) 5 * s (t, s)ds.
t
f
The arbitrage-free condition for bond markets can
then be applied to show that
µ f (t, T) 5 2 l(t)sf (t, T) 1 sP(t, T) s f (t, T).
These results are derived in Appendix D. See also
Ritchken and Sankarasubramanian (1995a) and the
discussion by Yong Yao of Sherris (1994).
From these results, it can be seen that the volatility
structure of the entire forward yield curve and the
market price of risk determine the evolution of the en-
tire yield curve through time. This information and the
initial yield curve are all that is required to generate
an arbitrage-free interest rate model. Equivalently a
term structure can specify the short-rate process as in
the more traditional models covered earlier.
In general, the evolution of the short rate in the
HJM model is non-Markov. The present level of the
short interest rates depends also on the level of inter-
est rates in the past. To implement this, a non-recom-
bining tree must be used or simulation techniques.
Heath, Jarrow and Morton developed the multifactor
case and specify the volatilities of all instantaneous
forward rates at all times, referred to as a volatility
structure. Ritchken and Sankarasubramanian (1995b)
show that specification of the volatility structure of
forward rates for single-factor models is important in
valuing options on interest rates and bonds. Even
though the model might fit the initial forward rate vol-
atilities, the structure of the volatility as a function of
maturity also determines the pricing performance of
the model.
3.11 Multiple-Factor Models
Many term structure models are single-factor models.
Bond prices are determined by the value of one state
variable or factor. This usually refers to the model
having only one source of uncertainty, in which case
yield changes for different maturities are perfectly
correlated. The single factor can be assumed to be
driven by multiple random shocks, in which case in-
stantaneous yield changes for different maturities
need not be perfectly correlated.
15
A single-factor model can be made to fit actual bond
price and volatility data by increasing the number of
parameters fitted. If actual bond prices are influenced
by more than one random factor, so that yields for
different maturities are not perfectly correlated, then
single-factor models are unlikely to be adequate for
hedging purposes although they might suffice for pric-
ing and valuation purposes. This is because they do
not capture all the possible future yield curve changes
and hence can not hedge against these.
Canabarro (1995) demonstrates how common one-
factor models can price bond options and interest rate
caps adequately but misprice interest rate spread op-
tions whose values depend on the difference between
two interest rates. He also demonstrates that the
hedging accuracy of single-factor models is poor.
Sherris (1995) uses Australian 13-week Treasury
note yields and 2-, 5-, and 10-year Treasury bond
yields from January 1972 to October 1994 to estimate
the number and importance of the random factors
driving yield curve changes. Using a factor model and
principal component analysis, he finds that three fac-
tors explain almost all the variability in yield curve
changes over this period.
The three factors can be interpreted as explaining
different types of change in the shape of the yield
curve. The first factor affects yields at all maturities
by a similar amount and in the same direction. This
factor can be interpreted as a parallel shift factor for
this reason. The changes are not exactly parallel,
since the effect at the short maturity is less than at
the medium to long maturities. This factor explains
as much as 83% of yield curve changes over the period
of study.
The second factor has an opposite effect on the
short and long yields. This factor can be interpreted
as a ‘‘slope’’ factor, since it changes the slope of the
yield curve. This second factor explains about 13% of
yield curve changes.
The third factor has a negative effect on medium
yields and a positive effect on short- and long-term
yields. For this reason, this factor can be interpreted
as a ‘‘curvature’’ factor. The third factor explains
about 3% of yield curve changes. In total, these three
factors explain more than 99% of yield curve changes.
These results are consistent with overseas studies.
However, compared with overseas studies, the slope
and curvature factor appear to be more important in
explaining the variance of yield curve changes in the
Australian bond market. A single-factor model would
be expected to explain only about 83% of yield curve
changes. This approach can also be used to estimate
16
historical interest rate volatilities for use in a HJM
multifactor model.
Heath, Jarrow, and Morton (1990b) use the results
of a principal components analysis by BARRA to de-
termine a volatility structure for a two-factor version
of their model and demonstrate its adequacy for pric-
ing a range of interest-rate-dependent securities.
Singh (1995) uses principal components analysis and
U.S. interest rate data from January 1983 through De-
cember 1992 to fit a three-factor Cox, Ingersoll, and
Ross square root process model. The parameters of
the model are quite unstable across time when differ-
ent time series data are used.
Other stochastic factors such as a model for the
inflation rate or for a stochastic volatility can be in-
cluded in the pricing model. Each of these factors can
be driven by a single or multiple random ‘‘shocks.’’
These additional factors are state variables for pricing
cash flows and the value of the cash flows will be a
function of these state variables.
Models used for short interest rates also assume
that the processes are difference stationary and hence
contain a unit root. Ang and Moore (1994) use the
augmented Dickey Fuller procedure to test for unit
roots with Australian interest rate data. They use the
official cash rate, the 13-week and 26-week Treasury
note yields, and the 2- and 10-year Treasury bond
yields from July 1969 to February 1994. They were
unable to reject the hypothesis of a unit root for any
of the series providing empirical support for differ-
ence stationary models.
3.12 Equilibrium Relationships
The long-run equilibrium relationship between yields
of different maturities contains useful information in
formulating a multifactor model. A number of time
series are said to be co-integrated when a linear com-
bination of them is stationary, even though the indi-
vidual series are not stationary. This means that if a
number of variables are co-integrated, then an under-
lying equilibrium relationship governs how they move
in relation to each other. Thus the individual series
can be nonstationary, but a difference relationship be-
tween the series can have a constant variance.
Co-integration analysis permits equilibrium rela-
tionships between economic time series to be exam-
ined without requiring the individual series to be
differenced. For interest rates, if the short-term spot
interest rate and the spreads between longer term
spot interest rates and the short-term interest rate are
co-integrated, as you might expect, then the term
NORTH AMERICAN ACTUARIAL JOURNAL, VOLUME 1, NUMBER 2
premiums are determined by long-term equilibrium
relationships.
A co-integrating vector relating interest rates of dif-
ferent maturities is consistent with theoretical models
of the term structure that impose a common stochas-
tic process for underlying rates. The significance of
using co-integration analysis when analyzing time se-
ries of economic variables is that forecasts that use
information about long-term relationships should out-
perform conventional time series forecasts that differ-
ence the data and remove this information. These
results are confirmed by a study by Bradley and
Lumpkin (1992) on the U.S. Treasury yield curve.
A number of different econometric techniques can
be used to obtain estimates of co-integrating vectors.
Ang and Moore (1994) follow Bradley and Lumpkin
but extend the analysis to using techniques that over-
come some of the technical shortcomings of the Brad-
ley and Lumpkin study. Testing Australian yields, Ang
and Moore find strong evidence of cointegration of
both nominal and real yields.
3.13 Pathwise Valuation
A significant issue in implementing path-dependent
and multifactor term structure models is the compu-
tation time involved. A number of techniques have
been developed recently to implement these models.
These models will prove the most useful for actuarial
liabilities, so these recent developments are relevant
to actuaries.
In many valuation and hedging problems, the
cash flows are path-dependent. Examples are the
cash flows on mortgage-backed securities or an op-
tion on the average of past interest rates. Standard
methods that rely on backward induction on a lat-
tice involve exploding lattices. Amin and Bodurtha
(1994) report the implementation of a single-factor
HJM model using a binary non-recombining lattice.
They use varying time interval lengths, rather than
fixed time intervals, and ten or less steps to obtain
accurate option prices for short-term options. This
approach is unlikely to be computationally feasible
for long-dated interest-sensitive cash flows found in
actuarial liabilities.
An alternative equivalent approach to backward in-
duction in a lattice is to use pathwise valuation (Tilley
1992). Instead of determining expected values and
discounting, pathwise valuation generates paths of in-
terest rates and cash flows and then values the cash
flows down each path. An expected value of the path-
wise values is then computed to obtain the value.
INTEREST RATE RISK MANAGEMENT
Such an approach handles path-dependent cash flows.
In many cases the interest rate paths are generated
as equally likely paths using simulation. An alterna-
tive approach is to weight selected paths according to
their contribution to the expected value, thus reduc-
ing the amount of computation. This technique un-
derlies the linear path space approach developed by
Ho (1992). This technique is not dissimilar to strati-
fied sampling, in which more observations are taken
in the parts of the region which are ‘‘more important.’’
A similar idea is importance sampling, which has also
been widely studied [see Glynn and Iglehart (1989)].
Pathwise valuation can handle path-dependent cash
flows. However, in order to value any set of cash flows
that involves optimal dynamic decisions, as for Amer-
ican-style options, the lattice approach is required. In
his linear path space Ho (1992) imposes a lattice
structure and weights these paths with probabilities,
allowing both American-style and path-dependent
cash flows to be valued. Pohlman and Wolf (1993)
demonstrate how to calculate the weights for Ho’s lin-
ear path space. Tilley (1993) demonstrates how sim-
ulation can be adapted to value American-style
options using another form of path-bundling.
Rose (1994) gives a method based on calculating
expected cash flows and discounting that allows for
both path-dependent and early-exercise features in
interest-rate-dependent cash flows. The technique al-
lows an approach similar to the traditional deter-
ministic approach to be applied. The expected cash
flows are calculated as effective cash flows that allow
for path dependence and early exercise. The tech-
nique uses the concepts of forward and backward in-
duction to determine the cash flows and then to value
them.
3.14 Simulation Techniques
A powerful method of implementing term structure
models is to use simulation. This technique uses the
pathwise approach to valuation. Tilley (1992) pro-
vides a comprehensive description of how this can be
done in practice. For most actuarial applications, it
will be essential to use variance reduction to speed
the computation.
Variance reduction techniques (VRTs) improve the
efficiency of normal Monte Carlo estimates. In simu-
lation problems using arbitrage-free models, generat-
ing a value on random paths of interest rates produces
random outputs. VRTs attempt to reduce the variance
of the output random variable of interest without dis-
turbing its expectation. VRTs, if used optimally, will
17
lead to increases in speeds of computation because
fewer simulations will need to be run. Lewis and Orav
(1989) note many limitations of VRTs, especially that
VRT’s may induce non-normality and very wild out-
liers. The smaller variance may not tell the entire
story of what is being done by a VRT.
Many of the presentations of VRTs in the literature
relate to operations problems and not to distributional
problems of the kind that occur in valuing securities.
Because VRTs are very problem specific, this means
it is not easy to just take VRT implementation ‘‘off the
shelf’’ from other problems. A good survey of using
VRTs in increasing the speed of algorithms is given
by McGeoch (1992). This paper does not attempt to
give a formal presentation of the statistical properties
of the VRTs; for this the reader is referred to the text-
books by Rubinstein (1981), Morgan (1984), and Law
and Kelton (1991). A number of VRTs are readily im-
plemented:
Antithetic Variates
First introduced by Hammersley and Morton (1956),
this VRT is based on the rationale that if the corre-
lation between two random variables, X1 and X2, is
very negative, the average of the negatively correlated
pair is less than the variance of the average of an
independent pair:
X1 1 X2 1
var 5 [var (X1) 1 var (X2)
2 4
1 2 cov (X1, X2)]
If var (X1)5var (X2)5s2, then
X1 1 X2 1
var 5 s 2 (1 1 r)
2 2
where r is the correlation between X1 and X2. If r is
negative, then the variance of the average of the an-
tithetic pair is less than that of the independent pair.
Antithetic variates are constructed by taking a set
of normal deviates U, and reversing the signs of the
deviates to obtain 2U. For a particular path p gen-
erated by random numbers (n1, n2, . . . , nT), an anti-
thetic path is generated by the random numbers (2n1,
2n2, . . . , 2nT).
Stratified Sampling
This involves breaking the sampling region D into m
disjoint subregions Di, i51, 2, . . . , m. Crude Monte
Carlo is used to estimate each interval separately. The
idea of this technique is to take more observations in
18
the parts of the region D that are more ‘‘important’’;
variance reduction is achieved by concentrating ob-
servations in the important subsets Di rather than by
sampling over the whole distribution. The problem
with stratified sampling is the determination of an op-
timal stratification plan. However, the results show
that in practice nonoptimal stratification can yield re-
sults far more efficient than crude Monte Carlo.
The practical adaptation of stratified sampling to a
simulation model involves dividing the sampling den-
sity for the diffusion factor into T strata of equal prob-
ability 1/T. A stratified sample can be created by
generating numbers over each of the T strata or using
the sample-mean Monte Carlo method, using the
mean of each stratum for each of the T strata. The
required random sample of T deviates is obtained by
shuffling the ordered stratified sample. An easy way
to do this is to assign each ni, i51 . . . T a random
number between 0 and 1. The random numbers are
then sorted into either descending or ascending order,
and the sample of T deviates is then shuffled.
Control Variates
Unlike the other VRTs discussed above, control vari-
ates operate at the level of the calculation of the ex-
pected value, rather than at the level of the generation
of the interest rate paths (the random numbers them-
selves). Like antithetic variates, they attempt to take
advantage of correlation between certain random var-
iables to obtain a reduction in variance. Unlike the
antithetic approach, the random variables do not have
to have a negative correlation. Suppose X is being
used to estimate a parameter q with E(X)5q. Now
consider another random variable, Y, with known ex-
pectation m. Then for any constant c (the control),
we can write:
Xc 5 X 2 c(Y 2 m).
Xc , like X, is an unbiased estimator of q with;
Var(Xc) 5 Var(X) 1 c 2 Var(Y) 2 2c cov(X, Y).
The maximum variance reduction is obtained when
c5[cov(X, Y)]/[var(Y)]. Note that Xc is less variable
than X if and only if:
1 this area has been nothing more than phenomenal in
cov(X, Y) . c Var(Y)
2
However, while cov (X,Y) and possibly var (Y) may
not be known, c can be taken simply as 51, as ap-
propriate. Like any ‘‘control’’ problem, there are sta-
bility concerns with the choice of covariates and the
NORTH AMERICAN ACTUARIAL JOURNAL, VOLUME 1, NUMBER 2
value of c. Ideally it is best to use a control variate
that is very similar to the security being valued. Clew-
low and Carverhill (1994) develop a control variate
approach based on the risk statistics of the derivative.
Quasi-random or Low-Discrepancy Random Numbers
A recent development in simulation techniques for
evaluating interest rate derivatives has been the use
of quasi-random numbers. This approach is based on
using deterministic points that are as uniformly dis-
tributed as possible instead of the pseudo-random
numbers used in Monte Carlo simulation. Paskov and
Traub (1995) demonstrate that a particular set of
quasi-random numbers called Sobol points produces
more accurate, smoother and faster convergence to
derivative values as compared with Monte Carlo sim-
ulation. Monte Carlo techniques can be sensitive to
the initial seed and this problem does not occur for
quasi-random numbers.
4. CONCLUSION
Actuaries often promote themselves as financial en-
gineers. The topics covered in this paper could well
be classified as ‘‘financial engineering’’ for valuation
and risk management of interest-rate-related cash
flows. Actuaries are becoming more involved in this
area as they move into quantitative areas of finance
and investment.
It is important to recognize that these techniques
have practical applications in the traditional actuarial
fields of practice. They are of relevance not only to
quantitative finance and investment actuaries but
more generally to life insurance, property and casu-
alty, and pension actuaries.
The paper includes many references, the majority
of which are dated after 1990. Apart from a number
of early, and significant, contributions to this area, it
was only in the middle and late 1980s that major the-
oretical advances were made that laid the foundation
for current research. A major proportion of this cur-
rent research is driven by practical application of the
techniques to interest rate risk management. The
amount of research by academics and practitioners in
the last few years. It continues to be an active re-
search area as a better understanding of the basis for
interest rate modeling is gained.
The authors hope that this paper will motivate
other actuaries to learn more about this exciting area
INTEREST RATE RISK MANAGEMENT
and provide a basis for learning how to develop and
apply these techniques to actuarial liabilities.
ACKNOWLEDGMENTS
The authors would like to thank Elias Shiu, Principal
Financial Group Professor of Actuarial Science, Uni-
versity of Iowa, for valuable (e-mail) discussion and
comments on an earlier version of this paper and two
anonymous referees for valuable comments. Any re-
maining errors or misconceptions remain the respon-
sibility of the authors. Andrew Ang would like to
acknowledge the support of AMP Investments during
his honours year studies, and Michael Sherris would
like to acknowledge the financial support of an Aus-
tralian Research Council (Small) Grant. An earlier
version of this paper was presented to the 1995 Con-
vention of the Institute of Actuaries of Australia, and
the authors thank participants at that convention for
their useful comments.
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APPENDIX A
Glossary of Key Terms
This glossary provides descriptions of the key con-
cepts and terminology used in the paper in alphabet-
ical order. It will serve as a useful reference point for
readers who are not familiar with the terminology.
Arbitrage-Free. An interest rate model is arbitrage-
free with respect to a set of securities if it is not pos-
sible to construct portfolios of these securities with
no net future cash flows that require non-zero net ini-
tial investment. An arbitrage-free model will produce
the market value of these securities when used to
price the securities.
Arrow-Debreu Securities. These are the most basic
or ‘‘primitive’’ securities in a pricing model that allows
for uncertainty from which all other securities can be
constructed. They are also referred to as state-contin-
gent securities. In a stochastic interest rate model,
Arrow-Debreu securities pay $1 at a specific maturity
and for a specified value of the future (uncertain) in-
terest rate, and zero for all other maturities and val-
ues of future interest rates.
Backward Induction. This is the process used in
the valuation of cash flows that depend on future val-
ues of interest rates. Once the cash flows have been
determined using forward induction, these are valued
working backwards in time calculating risk-adjusted
expected values and discounting.
22
Cointegration. A number of time series are said to
be co-integrated when a linear combination of them
is stationary, even though the individual series are not
stationary. This means that if a number of variables
are co-integrated, then an underlying equilibrium re-
lationship governs how they move in relation to each
other.
Convexity. Convexity measures the degree of rela-
tive curvature in the price/yield relationship for in-
terest-rate-dependent cash flows. It is calculated as
the second derivative of the price with respect to the
yield as a proportion of the price. In practice, the sec-
ond derivative is usually estimated numerically.
Complete Markets. Markets are said to be complete
if there exists a sufficient number of independent
traded securities to dynamically hedge the number of
random factors in a security market model. In a com-
plete market, interest-rate-dependent cash flows can
be perfectly replicated with portfolios of traded
securities.
Delta. The delta of an option is the sensitivity of
the value of the option to changes in value of the un-
derlying asset value. In the case of interest-rate-de-
pendent cash flows, the sensitivity of the value of the
cash flows to changes in interest rates is often cal-
culated as the delta. For interest-rate-dependent cash
flows where the cash flows are those of a traded fi-
nancial instrument such as an option on a bond, the
delta can be calculated as the sensitivity of the value
of the option to changes in the value of the bond. This
definition of delta is useful for hedging purposes
where an underlying financial instrument actually
trades since it gives the hedge ratio.
Diffusion Process. A continuous time Markov pro-
cess that assumes small changes in a time series has
two components, a drift and a diffusion. The drift rep-
resents the expected change in the series, and the
diffusion provides the random change. The drift and
diffusion components can take a number of different
forms, allowing for mean reversion in the drift and for
a variety of distributions in the diffusion.
Duration. This is the weighted average time to re-
ceipt of the cash flows, where the weights are the
present value of the cash flows.
Effective Duration. This is (minus) the sensitivity
of the value of the cash flows to a small parallel shift
in interest rates as a proportion of the value of the
cash flows. It is also referred to as modified duration
for bond cash flows. It is related to duration but cal-
culated as a sensitivity and not as a weighted average
time to receipt of the cash flows. This difference in
the method of calculating effective duration is important
NORTH AMERICAN ACTUARIAL JOURNAL, VOLUME 1, NUMBER 2
when considering interest rate derivatives such as fu-
tures, swaps, and options.
Expectations Hypothesis. The expectations hypoth-
esis has different versions with different assumptions.
In one form it states that the expected one-period re-
turns on all bonds are equal to the prevailing spot rate,
and thus for a given holding period the long-term rate
is an unbiased average of the current spot rate and
expected future spot rates (or one-period forward
rates). Under other theories of the term structure such
as the liquidity premium hypothesis and preferred hab-
itat theory, risk premiums are assumed for different
maturities.
Equilibrium Model. Equilibrium interest rate mod-
els determine bond prices and the value of other in-
terest-rate-contingent claims based on assumptions
about the risk preferences of investors and the sto-
chastic nature of capital markets.
Forward Induction. This is the process of determin-
ing future interest-rate-dependent cash flows by work-
ing forward from the current time. The process is used
to determine future interest rate paths and then to de-
termine future cash flows that depend on these interest
rate paths. Forward induction usually refers to the pro-
cess of fitting the parameters of an arbitrage-free in-
terest rate model to a current yield curve for each
future time period by working forward in time.
Forward Interest Rate. A forward interest rate ap-
plies to a fixed time period commencing at a pre-spec-
ified future (or forward) time. At the current date,
forward rates are known and can be derived from the
yields to maturity or the spot rates. On future dates,
the forward rates that will apply for forward time pe-
riods at these dates are uncertain and need to be mod-
eled as stochastic variables.
Integration (of a Time Series). If a time series is
integrated of order p, then p-th-differences are re-
quired to produce a stationary series. Thus if a series
is integrated of order 1, then first differences will be
stationary. The order of integration of a series has im-
portant implications for modeling and inference.
Lattice Model. A discrete model of interest rates,
or asset prices, generates future possible values on a
lattice. The binomial model with two possible values
conditional on the current value generates a lattice of
values with the number of nodes in the lattice either
increasing by one or doubling, depending on whether
values in the lattice recombine.
M2. The weighted ‘‘variance’’ of the time to receipt of
a set of cash flows around the duration of the cash flows
where the weights are the present values of the cash
flows. For asset cash flows, the weights are positive and
INTEREST RATE RISK MANAGEMENT
M2 is a variance. This will not be the case for net cash
flows, equal to asset cash flows minus liability cash
flows, since some of the net cash flows and hence some
of the weights could be negative.
Market Price of Risk. For a security or portfolio
that is exposed only to a specific risk factor, the mar-
ket price of risk is defined as the excess return over
the short rate per unit of volatility. The market price
of interest rate risk is defined as the excess return on
a bond over the short rate per unit of volatility of the
bond price.
Markov Process. A Markov process has the prop-
erty that all future values depend only on the current
value of the process. For interest-rate-modeling pur-
poses, such processes are computationally simpler to
implement.
Martingale. A martingale is a stochastic process
with the property that its expected value at any future
time is equal to its current value.
Multiple Factor Model. A model of an interest rate
series, or asset price series, where future values are
determined by multiple random factors or ‘‘shocks.’’
The nature of these random shocks can be estimated
from historical data by using principal components or
factor analysis.
Short Rate. In a continuous time model the ‘‘short’’
rate is usually defined to be the instantaneous spot
interest rate. In a discrete model the short rate is the
one-period spot interest rate. Often the term ‘‘the spot
interest rate’’ is used to refer to the short rate as de-
fined here.
Single-factor Model. A model of an interest rate se-
ries, or asset price series, that has only one random
factor determining the future values of the series.
Spot Interest Rates. These are the yields to matur-
ity on zero-coupon bonds for varying maturities. The
one-period spot interest rate is the yield to maturity
on a zero-coupon bond maturing in one time period.
The instantaneous spot interest rate in a continuous
time model is the rate applying from time t to t1dt.
Stationary Series. There are various levels of sta-
tionarity. A common definition for a series to be sta-
tionary is that the mean and variance are constant
and the autocorrelations do not vary through time. A
changing mean could be modeled by using a polyno-
mial trend. If after fitting the trend the remaining se-
ries has a constant mean, then the series is ‘‘trend’’
stationary. Random ‘‘shocks’’ do not have an effect on
the long run level of the series. If it is necessary to
difference the series to obtain a stationary mean, then
the series is said to be ‘‘difference’’ stationary. In this
case random ‘‘shocks’’ have a permanent influence on
23
the level of the series, and the trend is stochastic. It
is possible for the variance of the series to be made
constant by transformation of the series such as a log-
arithmic transformation for cases in which the vari-
ance increases with the level of the series.
Term Structure of Interest Rates. This is the struc-
ture of interest rates as time to maturity varies with
the effect of all other factors such as coupon level,
liquidity, and credit risk removed. The term structure
reflects only variations in interest rates with respect
to term. The spot yield curve for zero-coupon govern-
ment bonds is most often used to represent the term
structure.
Variance Reduction Techniques. Used in simula-
tion, variance reduction techniques (VRTs) improve
the efficiency of Monte Carlo estimates. VRTs work
by reducing the variance of the random variable of
interest without disturbing its expectation. Some
common VRTs used in interest rate modeling are an-
tithetic variates, stratified sampling, control variates,
importance sampling, path-bundling, and the linear
path space.
Volatility. This term has many different meanings.
The term is sometimes used to refer to (minus) the
differential of the value of a security with respect to
the interest rate as a proportion of the value. This is
more often called modified duration or effective du-
ration in financial markets. In option pricing the term
volatility refers to the instantaneous standard devia-
tion of the rate of return on the underlying asset.
Wiener Process (Brownian Motion). A diffusion
process with increments that are stationary, indepen-
dent, and normally distributed with variance propor-
tional to the time interval for the increment.
Yield Curve. The plot of yield against term. Most
often for the yields to maturity but also for spot and
forward interest rates.
APPENDIX B
Derivation of the Standard PDEs for
Security Valuation
Consider the stochastic process for the factor X:
dX 5 µ(X, t)dt 1 s(X, t)dZ (1)
where dZ is a standard Wiener process.
Let H (X, t) and G(X, t) be the values of two secu-
rities that are functions of X and t. These processes
may be described as:
dH
5 µH (X, t)dt 1 sH (X, t)dZ (2a)
H
24 NORTH AMERICAN ACTUARIAL JOURNAL, VOLUME 1, NUMBER 2

and and
dG sV (X, t) 5 VX s(X, t) (9b)
5 µG (X, t)dt 1 sG (X, t)dZ (2b)
G
Substitute (9a) and (9b) into (8) to obtain the partial
Form a portfolio with value P consisting of [sG (X, t)]/H differential equation, which must be satisfied by V:
of the first security H and 2 [sH (X, t)]/G of the second
V X [µ(X, t) 2 l(X, t)s(X, t)]
security G so that:
P 5 sG (X, t) 2 sH (X, t) (3a) 1
1 V s2(X, t) 1 Vt 5 r(t)V
and 2 XX

dP 5 sG (X, t)dH 2 sH (X, t)dG (3b) To obtain a solution for V, impose boundary condi-
tions on this pde and solve it analytically or
Substitute (2a) and (2b) to obtain: numerically.
dP 5 [µH (X, t)sG (X, t) 2 µG (X, t)sH (X, t)]dt (4)
Since this is riskless, it must earn the risk-free rate APPENDIX C
r(t):
dP 5 r(t) Pdt (5) The Discretization of Continuous Models
This appendix derives lattice models from finite dif-
Substituting (2a), (2b), and (3a), (3b) into (5) gives:
ference approximations to the fundamental pde for
µH (X, t)sG (X, t) 2 µ G (X, t)sH (X, t) (6) pricing securities. For convenience, it is assumed that
5 r(t)[sG (X, t) 2 sH (X, t)] dr5µrdt1s rdZ, so that r is a lognormal process,
P5P(r,t), and that the bond market is arbitrage-free.
which simplifies to: The market price of risk is incorporated into the drift
µ H (X, t) 2 r(t) µ (X, t) 2 r(t) term, so no market price of risk explicitly appears in
5 G 5 l(X, t) (7) the pde. The pde is restated here for convenience,
sH (X, t) sG (X, t)
where subscripts denote partial derivatives:
where l is the market price of risk. Assuming a
complete market, where it is possible to replicate the 1
P s2r 2 1 Pr µr 1 Pt 5 rP (1)
payoffs of a security V(X,t), then 2 rr
µ V (X, t) 2 r(t) Explicit finite difference approximations to the partial
5 l(X, t),
sV (X, t) derivatives can be used to derive trinomial or bino-
mial lattices. References are He (1990), Hull (1993),
which can be written as:
Jamshidian (1991b), and Nelson and Ramaswamy
µ V (X,t) 2 r(t) 5 l(X,t)s V (X,t) (8) (1990).
Application of Itô’s lemma gives dV as: To obtain a trinomial tree, substitute the following
difference approximations to the partial derivatives:
1
dV 5 VX dX 1 V dX 2 1 Vt dt Pi: j11 2 Pi: j
2 XX Pt 5 (2a)
Dt
5 VX [µ(X, t)dt 1 s(X, t)dZ]
where the index i refers to increments in r of size Dr,
1
1 V s2(X, t)dt 1 Vt dt j refers to increments in t of size Dt.
2 XX
Pi11: j11 2 Pi21: j11
5 @VX µ(X, t) 1
1
V s2(X, t) 1 Vt
2 XX # Pr 5
2Dr
(2b)

dt 1 VX s(X, t)dZ Pi11: j11 1 Pi21: j11 2 2Pi: j11

Prr 5 (2c)
Dr 2
and so the parameters for the drift and diffusion for
dV are: Equation (2a) is a first difference, (2b) is a central
difference, and (2c) is a second difference.
1
µ V (X, t) 5 VX µ(X, t) 1 V s2(X, t) 1 Vt (9a)
2 XX
INTEREST RATE RISK MANAGEMENT 25

Substitute (2a–c) into (1) to get: From Itô’s Lemma:

Pi: j
rPi: j 1
Dt
5 Pi11: j11
1
2 @ 1
iµ 1 si 2
2 # dx 5 xr dr 1
1
x dr 2 1 xt dt
2 rr
(6)

1 Pi21: j11
1
2@ 1 2
iµ 1 si 1 Pi: j11
2 # @ si 2 1
1
Dt # (3) Substituting (5b–d) into (6) yields:
µ s
Equation (3) can be written as: dx 5 bdt 1 dZ, b 5 2 (7)
s 2
a*j Pi11: j11 1 b*j Pi: j11 1 c*j Pi21: j11
Pi: j 5 (4a) The pde in terms of ]r must be transformed into
1 1 rDt
terms of ]x where r(x,t) is the inverse of x(r,t). Let
where p(x,t) 5 P(r,t) with:
1 1 Pr 5 px xr by the chain rule
a*j 5 iµDt 1 s2 i2 Dt (4b)
2 2
px
b*j 5 1 2 s2 i2 Dt (4c) Pr 5 (8a)
sr

c*j 5 2 ~12 iµDt 2 12 s i Dt!

2 2
(4d)
Prr 5 pxx xr2 1 px xrr by the product rule.
Simplifying (8b) gives:
(8b)

a*j 1 b*j 1 c*j 5 1. (4e) pxx p

Prr 5 2 x2 (8c)
Note that since these sum to 1 they can be interpreted s2 r2 sr
as (pseudo) probabilities.
Substituting (8b–c) into the pde (1) and simplifying
The result [in 4(a)] states that the PV of a bond at
gives:
state i, time t, is a weighted average of the value of
the bond at time t11 discounted by the one-period 1
p 1 b px 1 pt 5 rp (9)
spot rate at state i on a trinomial lattice. Here a*, b*, 2 xx
and c* are the (risk-neutral) probabilities:
Applying finite differences as (2a–c), except now in
terms of p, gives:
P(i+1)
a*
rpi: j 1
pi: j
Dt
5 pi11: j11 ~b
2D x
1
1
2D x2 !
b*
P(i) P(i) 1 pi21: j11 ~2D1x 2
2
b
2D x! p
2 i: j11
D x2
p
1 i: j11
Dt
(10)

c* In continuous time:
dx 5 bdt 1 dZ (11a)
P(i–1)
dx 5 dt2

time j time j+1 and in discrete time the equivalent first-order

approximations are:
A binomial tree can be derived from the pde by mak-
ing the change of variable: Dx ' bDt 1 j=Dt (11b)

* s(r,t) 5*
Dx ' Dt
2
dr dr ln r
x(r,t) 5 5 (5a)
sr s where j;N(0, 1).
1 Simplifying (10) gives:
xr 5 (5b)
sr
1
pi: j 5
1
1 1 rdt @ 1
p
2 i11: j11
(b=dt 1 1)
xrr 5 2 (5c)

xt 5 0
sr 2
(5d)
1
1
p
2 i21: j11
(1 2 b=dt) # (12)
26 NORTH AMERICAN ACTUARIAL JOURNAL, VOLUME 1, NUMBER 2

Or in discrete time: From Itô’s lemma:

1 1 2
pi: j 5 [ppi11: j11 1 (1 2 p) pi21: j11] (13a) d ln [P(t,T)] 5 [µ P (t,T) 2 s (t,T)]dt
1 1 rDt 2 P
1 2 sP (t,T)dz(t) (4)
where p 5 [1 1 b =Dt] (13b)
2
and
Equations (13a) and (13b) can be interpreted as a
binomial model, where p and (12p) are the binomial ]
df(t,T) 5 2 [d ln P(t,T)]
risk-neutral probabilities: ]T
] 1
52 [µ (t,T) 2 s 2P(t,T)]dt
p(i+1) ]T P 2
]
1 s (t,T)dz(t). (5)
]T P
p(i)
Comparing terms in (2) and (5) gives
] 1 ] 2
1– µ f (t,T) 5 2 µ P (t,T) 1 s (t,T) (6)
]T 2 ]T P
p(i–1)
]
time j time j+1 sf (t,T) 5 s (t,T) (7)
]T P
This appendix has shown that the discrete trinomial Rearranging (6), differentiating the squared volatility
and binomial models are in fact discrete approxima- term and substituting (7) gives:
tions to the continuous time approaches. Similarly, a
discrete lattice can always be developed to be consis- ]
µ (t,T) 5 2µ f (t,T) 1 sP (t,T)sf (t,T) (8)
tent with the continuous time framework with the ]T P
right restrictions and corresponding algorithm. These Integrating (7) gives:
results are then very important in understanding how
to select discrete lattice models.
sP (t,T) 5 * t
T
sf (t,s)ds. (9)
The arbitrage-free condition for bond markets is that
APPENDIX D
µ P (t,T) 5 r(t) 1 l(t)sP (t,T) (10)
The Relationship of the Stochastic
Differentiating (10) and using (7) gives
Processes of Bond Prices, Forward Rates,
and Spot Rates ] ]
µ P (t,T) 5 l(t) s (t,T) 5 l(t)sf (t,T) (11)
Let P(t,T) denote the price at time t of a T-maturity ]T ]T P
zero-coupon bond with instantaneous return given by: Substitute (11) into (8) and rearrange to get
dP(t,T)
5 µ P (t,T)dt 2 sP (t,T)dz(t). (1) µ f (t,T) 5 2l(t)sf (t,T) 1 sP (t,T)sf (t,T). (12)
P(t,T)
Short-rate dynamics follow from the dynamics of the
The instantaneous forward rates at time t applying
forward rate curve since r(t)5f(t,t).
from time T to T1dT follow a diffusion of the form
df(t,T) 5 µ f (t,T)dt 1 sf (t,T)dz(t). (2)
Since the forward rates and bond prices are related Discussions on this paper will be accepted until
by the definition October 1, 1997. The authors reserve the right to re-
ply to any discussion. See the Table of Contents page
] ln P(t,T) for detailed instructions on the preparation of dis-
f(t,T) 5 2 (3)
]T cussions.