AMF 241 Interest Rate Models

Bonds and Interest Rates

Timothy Robin Teng
1 / 54
We will assume that there is an underlying probability space

(, F, P) with the {Ft } as the natural filtration of the P-brownian
motion {Wt }.
2 / 54
Zero coupon bonds and related interest rates

Definition
A zero coupon bond (or pure discount bond) with maturity date T ,
also called a T -bond, is a contract which guarantees its holder the
payment of one unit of currency at time T , with no intermediate
payments. The contract value at time t < T is denoted by P(t, T ).
The convention that the payment at the maturity date, known as the
principal value or face value, equals one is made for computational
convenience.
Note that P(t, t) = 1 for all t.
3 / 54
The bond price P(t, T ) is also a stochastic object with two variables
t and T , and for each outcome in the underlying sample space, the
dependence upon these variables is different.
Fix t; P(t, T ) is a function of maturity date T
The function provides prices for bonds of all possible maturities
at a fixed time t. The graph of the function is called bond
price curve at t, or the term structure of t. Typically it will
be a very smooth graph, i.e. for each t, P(t, T ) is differentiable
with respect to T .
4 / 54
Fix T ; P (t, T ) (as a function t) will be scalar stochastic process

The process gives the prices, at different times, of the bond with
fixed maturity T , and the trajectory will typically be very
irregular.
5 / 54
Interest Rates
We may now define a number of interest rates based on the zero

coupon bond, and the basic construction is as follows:
We consider three time instants, namely the time t at which the rate
is considered, and two other points in time T and S, such that
t < S < T . The goal is to write a contract at time t which allows us
to make an investment of one (dollar) at time S, and to have a
deterministic rate of return (determined at the contract time t) over
the interval [S, T ].
6 / 54
At time t we sell one S-bond. This will give us P(t, S) dollars.

We use this income to buy exactly P(t, S)/P(t, T ) T -bonds.
Thus our net investment at time t equals zero.
At time S, the S-bond matures, so we are obliged to pay out
one dollar.
7 / 54
At time T , the T -bonds mature at one dollar a piece, so we will

receive the amount P(t, S)/P(t, T ) dollars.
The net effect of all this is that, based on a contract at t, an
investment of one dollar at time S has yielded P(t, S)/P(t, T )
dollars at T .
Thus, at time t, we have made a contract guaranteeing a
riskless rate of interest over the future interval [S, T ]. Such an
interest rate is called a forward rate.
8 / 54
We now proceed to compute the relevant interest rates implied by

the construction above. The simple forward rate (or LIBOR rate) L,
is the solution to equation
1 + (T S)L =
P(t, S)
P(t, T )
whereas the continuously compounded forward rate R is the solution

to the equation
P(t, S)
e R(T S) =
P(t, T )
The simple rate notation is the one used in the market, whereas the
continuously compounded notation is used in theoretical contexts.
9 / 54
The simple forward rate for [S, T ] contracted at t, henceforth

referred to as the LIBOR forward rate, is defined as

1
P(t, T ) P(t, S)
L(t; S, T ) =
T S
P(t, T )
The simple spot rate for [S, T ], henceforth referred to as the
LIBOR spot rate, is defined as

1
P(S, T ) 1
L(S, T ) := L(S; S, T ) =
T S
P(S, T )
10 / 54
The continuously compounded forward rate for [S, T ]

contracted at t is defined as
R(t; S, T ) =
log P(t, T ) log P(t, S)

T S
The continuously compounded spot forward rate, R(S, T ),

for the period [S, T ] is defined as
R(S, T ) := R(S; S, T ) =
log P(S, T )
T S
11 / 54
The instantaneous forward rate with maturity T , contracted

at t, is defined by
f (t, T ) =
log P(t, T )
T
The instantaneous short rate at time T is defined by

rt = f (t, t)
12 / 54
We note that the spot rates are forward rates where the time of
contracting coincides with the start of the interval over which the
interest rate is effective, i.e. t = S.
The instantaneous forward rate is the limit of the continuously
compounded forward rate when S T ; it can be viewed as the
riskless interest rate, contracted at t, over the infinitesimal interval
[T , T + dT ].
13 / 54
The short rate of interest rt , is the (annualized) interest rate at which

an entity can lend or borrow money over an infinitesimally small
interval [t, t + dt]. As opposed to stock prices, short rates tend to
stay within a certain range, hence they are often described as mean
reverting processes. From the short rate rt , we can define an
important instrument in the market which is the money market
account, representing a (locally) riskless investment where profit is
accrued continuously at rate rt .
14 / 54
Remark: One should note that in practice, the process rt is not

observable. The shortest maturity rate available is the overnight rate,
which is conceptually quite different from an instantaneous spot rate.
Nevertheless, it is quite frequent that one-night and even one-month
or three-month rates are used as proxies for rt in the empirical term
structure literature
15 / 54
Definition
(Money-market account). We define Bt to be the value of a bank
account at time t R+ , and its given by
Bt = e
Rt
0
r (u)du
that is, it evolves according to the following initial value problem:

dBt = rt Bt dt, B0 = 1
16 / 54
As an immediate consequence of the definitions we have the following

useful formula.
Lemma
The price of the bond can be expressed as
Z T

P(t, T ) = exp
f (t, u)du
t
and for t s T , we have

Z
P(t, T ) = P(t, s) exp

f (t, u)du
17 / 54
Relations between df (t, T ), dP(t, T ) and dr (t)

We will consider dynamics of the following form:
Short rate dynamics
dr (t) = a(t)dt + b(t)dWt
(1)
Bond price dynamics

dP(t, T ) = P(t, T )m(t, T )dt + P(t, T )v (t, T )dWt
(2)
Forward rate dynamics

df (t, T ) = (t, T )dt + (t, T )dWt
(3)
The processes a(t) and b(t) are scalar adapted processes, whereas
m(t, T ), v (t, T ), (t, T ) and (t, T ) are adapted processes paramaterized by
time of maturity T . The interpretation of the bond price equation (2) and the
forward rate equation (3) is that these are scalar stochastic differential equations
(in the t-variable) for each fixed time of maturity T .
18 / 54
We will study the formal relations which must hold between bond
prices and interest rates, and for this we establish the following
assumptions:
1
For each fixed , t all the objects m(t, T ), v (t, T ), (t, T ) and
(t, T ) are assumed to be continuously differentiable in the
T -variable. This partial T -derivative is sometimes denoted by
mT (t, T ) etc.
All processes are such that we can differentiate under the
integral sign as well as interchange the order of integration.
The main result is as follows. Note that the results below hold,
regardless of the measure under consideration, and in particular, we
do not assume that markets are free of arbitrage.
19 / 54
Proposition
.
If P(t, T ) satisfies
dP(t, T ) = P(t, T )m(t, T )dt + P(t, T )v (t, T )dWt
the the forward rate dynamics have
df (t, T ) = (t, T )dt + (t, T )dWt
where and are given by

(t, T ) = vT (t, T ) v (t, T ) mT (t, T )
(t, T ) = vT (t, T )
20 / 54
Proposition
2. If f (t, T ) satisfies
df (t, T ) = (t, T )dt + (t, T )dWt
then the short rate satisfies
dr (t) = a(t)dt + b(t)dWt
where
a(t) = fT (t, t) + (t, t)

b(t) = (t, t)
21 / 54
Proposition
3. If f (t, T ) satisfies
df (t, T ) = (t, T )dt + (t, T )dWt
then P(t, T ) satisfies

1
dP(t, T ) = P(t, T ) r (t) + A(t, T ) + S 2 (t, T ) dt + P(t, T )S(t, T )dWt
2
where
RT
A(t, T ) = t (t, s)ds
RT
S(t, T ) = t (t, s)ds
22 / 54
Short rate models
Interest models behave differently from stock prices and require the
development of specific models to account for properties such as
positivity, boundedness and return to equilibrium. Refer to the other
handouts for a list of short rate models
For this section, we consider classical time homogenous short rate
models, i.e. the assumed short rate dynamics depended only constant
coefficients. The focus would be on the Vasicek (1977), the Dothan
(1978) and the Cox, Ingersoll and Ross (1985) models.
23 / 54
The Vasicek Model (1977)

Vasicek introduced the first model to capture the mean reversion
property of interest rates. In the Vasicek model, which is based on
the Ornstein-Uhlenbeck process, the short term interest rate process
rt satisfies the SDE
drt = k ( rt ) dt + dWt
where k, and are positive constants. The model has the property
of being statistically stationary in time, i.e. the distribution of rt rs
depends only on t s. However, for each time t, the short rate rt
can be negative with positive probability.
24 / 54
Solving the above equation will give us,

Z t
kt
ku
rt = + e
r0 +
e dWu
0
Z t

kt
kt
+
e k(tu) dWu
= r0 e
+ 1e
0
and for s t
rt = rs e
k(ts)
+ 1e
k(ts)
Z
+
e k(tu) dWu
25 / 54
Hence, rt conditional on Fs is normally distributed with mean and

variance given respectively by

Z t

k(ts)
k(ts)
k(tu)
E [ rt | Fs ] = E rs e
+ 1e
+
e
dWu Fs

Zs t

k(ts)
k(ts)
k(tu)
= rs e
+ 1e
+E
e
dWu Fs
Z st

k(ts)
k(ts)
k(tu)
= rs e
+ 1e
+E
e
dWu
s

= rs e k(ts) + 1 e k(ts)
26 / 54
i
h

Var [rt | Fs ] = E (rt E [ rt | Fs ])2 Fs
" Z
2 #
t

= E 2
e k(tu) dWu Fs

s
#
"Z
2
t
2
k(tu)
= E
e
dWu
s
2
Z
= E
2k(tu)
2k(tu)

du
s
2
Z
= E

du

2
1 e 2k(ts)
2k
27 / 54
Based on the conditional mean and variance, the short rate rt is

mean reverting, since the expected rate approaches the value as t
goes to infinity. The fact that can be regarded as a long term
average rate could be inferred from the dynamics of the SDE itself.
Notice that the drift of the process rt is positive whenever the short
rate is below and negative otherwise, so that r is pushed, at every
time t, closer towards the average level .
28 / 54
The Dothan Model (1978)

The Dothan model basically follows the GBM dynamics for the short
rate
drt = art dt + rt dWt
in which case

rt = rs exp

1 2
a (t s) + (Wt Ws )
2
for s t.
29 / 54
Hence, rt conditional on Fs is lognormally distributed with mean and

variance given by

1 2
E [rt | Fs ] = E rs exp
a (t s) + (Wt Ws ) Fs
2

1 2
= rs e (a 2 )(ts) E e (Wt Ws ) |Fs

1 2
= rs e (a 2 )(ts) E e (Wt Ws )
Wt Ws N(0, t s)
1 2
1
2
= r e (a 2 )(ts) e 2 (ts)
s
= rs e a(ts)
30 / 54

Var [ rt | Fs ] = E rt2 |Fs (E [rt |Fs ])2
i
h
2
= E rs2 e (2a )(ts)+2(Wt Ws ) |Fs rs2 e 2a(ts)

2
= rs2 e (2a )(ts) E e 2(Wt Ws ) |Fs rs2 e 2a(ts)

2
= r 2 e (2a )(ts) E e 2(Wt Ws ) r 2 e 2a(ts)
s
= rs2 e (
1
(2)2 (ts)
2
)(ts) e
rs2 e 2a(ts)
h 2
i
= rs2 e 2a(ts) e (ts) 1
2a 2
31 / 54
The lognormal distribution implies that rt is always positive for each

t, so that the main drawback of Vasicek is addressed here. However,
the process rt is mean-reverting if and only if a < 0, with the
reversion level that must be necessarily equal to 0.
Remark: An alternative to this, which is also a lognormal short rate
model, is the Exponential Vasicek model, where the short rate is
always mean reverting (refer to handout for the formulation and
properties of the model)
32 / 54
Cox-Ingersoll-Ross (1985)
The general equilibrium approach developed by Cox, Ingersoll and
Ross (1985) led to the introduction of a square root term in the
diffusion coefficient of the instantaneous short rate dynamics
proposed by Vasicek. The resulting model, which is also mean
reverting, has been a benchmark for many years because of its
analytical tractability and the fact that the short rate is always
positive.
33 / 54
The model formulation in this case is given by
drt = k( rt )dt + rt dWt

where k, and are positive constants. The condition 2k > 2 has
to be imposed to ensure that the origin is inaccessible to the process
described above, so that we can grant that rt remains positive.
34 / 54
Here rt follows a noncentral chi-squared distribution. Denoting pY

the density function of the random variable Y ,
prt (x) = p2 (v ,t )/ct (x) = ct p2 (v ,t ) (ct x)
4k
4k
v
=
ct =
2 (1 exp(kt))
2
t = ct r0 exp(kt)
where the noncentral chi-squared distribution function 2 (, v , ) with

v degrees of freedom and non-centrality parameter has density
p2 (v ,) (z) =
X
e /2 (/2)i
i=0
p(i+v /2,1/2) (z) =
i!
p(i+v /2,1/2) (z)
(1/2)i+v /2 i1+v /2 z/2

z
e
= p2 (v +2i) (z)
(i + v /2)
with p2 (v +2i) (z) denoting the density of a central chi-squared

distribution with v + 2i degrees of freedom.
35 / 54
The mean and variance of rt conditional on Fs are given by

E [ rt | Fs ] = rs e k(ts) + (1 e k(ts) )

2 k(ts)
2
Var [ rt | Fs ] = rs
e
e 2k(ts + (1 e k(ts) )2
k
2k
36 / 54
We remark that while the above time homogenous models allow for
the analytical pricing of bond and bond options, these models dont
tend to fit well with initial observed term structure in the market,
regardless of how the parameters are chosen. Consequently, some
practitioners are reluctant to apply such kinds of models. Hence, we
may consider time dependent extensions of the above models. For
example, the Hull White model
drt = k (t rt ) dt + dWt
is a time dependent extension of the Vasicek model. The CIR also
admits a similar time-dependent extension (refer to handout for more
models).
37 / 54
Bond price and risk neutral measure
We highlight the relationship between the bond price P(t, T ) and the
short rate process {rt }tR+ under the absence of arbitrage condition
by considering the following scenarios:
The short rate is a deterministic constant r > 0. In this case,
P(t, T ) should satisfy
e r (T t) P(t, T ) = P(T , T ) = 1,
t [0, T ]
therefore
P(t, T ) = e r (T t) ,
t [0, T ]
38 / 54
The short rate is time dependent and deterministic function rt .

In this case, it can be shown that
P(t, T ) = e
RT
t
ru du
t [0, T ]
(4)
39 / 54
The short rate is a stochastic process rt . We remark that (4)

does not make sense since the price P(t, T ) being set at time t,
can depend only on information known up to time t. In fact, the
price for this case would be given by
i
h RT

P(t, T ) = EP e t ru du Ft , t [0, T ]
It
where the expectation is under the risk neutral measure P.
gives
us the best possible estimate of the future quantity
R
tT ru du
e
given information known up to time t. Furthermore, as
a conditional expectation with respect to Ft , the bond price
P(t, T ) is Ft -measurable.
40 / 54
is equivalent to P, under
We remark that the risk neutral measure P
s)}0sT defined by
which for all s [0, T ], the process {P(t,
s) = e
P(t,
Rt
0
ru du
P (t, s) =
P (t, s)
Bt
is a P-martingale.
41 / 54
For the succeeding discussion on bond pricing, we will assume that

and that the filtration
the short rate process is under the measure P,
{Ft } is generated by the P-Brownian

motion {Wt }. Indeed, the term
structure, as well as prices of all other interest rate derivatives, are
completely determined by specifying the dynamics of the short rate
and the objective probability measure P can just be ignored.
under P,
42 / 54
Bond price under the Vasicek Model

We recall that the in the Vasicek model, the short rate dynamics is
described by
drt = (a brt )dt + dWt
with the solution
rt = r0 e
bt

a
+
1 e bt +
b
e b(tu) dWu
43 / 54
The arbitrage price of the bond is given by

h RT i

P(t.T ) = EP e t rs ds Ft = e A(t,T )B(t,T )rt
where
B(t, T ) =

1
1 e b(T t)
b
and
A(t, T ) =
2ab 2
2 2
(B(t,
T
)
T
+
t)
B (t, T )
2b 2
4b
44 / 54
Bond price under the CIR Model

Recall that the CIR model for short rate is given by
drt = k( rt )dt + rt dWt

The price at time t of a zero-coupon bond with maturity T is
P(t, T ) = A(t, T )e B(t,T )rt
where
2he (k+h)(T t)/2
A(t, T ) =
2h + (k + h) (e (T t)h 1)

2 e (T t)h 1
B(t, T ) =
2h + (k + h) (e (T t)h 1)
h =
k 2 + 2 2

2k/2
45 / 54
Affine Term Structure Model

Affine term structure models are interest rate models where the
continuously compounded spot rate R(t, T ) is an affine function in the
short rate rt , that is
R(t, T ) = (t, T ) + (t, T )rt
where and are deterministic functions of time. If this happens, the
model is said to possess an affine term structure.
46 / 54
This relationship is always satisfied when the zero-coupon bond price

can be written in the form
P(t, T ) = C (t, T )e B(t,T )rt
since then clearly it suffices to set
(t, T ) = ln C (t, T )/(T t)
(t, T ) = B(t, T )/(T t)
Both Vasicek and CIR models seen earlier are affine models, since
their corresponding bond prices has the above form. The Dothan
model is not an affine model.
47 / 54
Now assume that we have the risk neutral dynamics for the short rate
given by
drt = b(t, rt )dt + (t, rt )dWt
The conditions for which b and admits an affine term structure is
given by
b(t, x) = (t)x + (t)
p
(t, x) =
(t)x + (t)
that is, b and 2 are also affine functions themselves.
48 / 54
Forward Rate and the HJM condition

We recall that instantaneous forward rate with maturity T ,
contracted at t, is defined by
f (t, T ) =
log P(t, T )
T
If the short rate folows the Vasicek stochastic interest rate model,
that is
drt = (a brt )dt + dWt
then
f (t, T ) = rt e b(T t) +

2
a
2
1 e b(T t) 2 1 e b(T t)
b
2b
49 / 54
Now suppose we determine the dynamics of the process f (t, T ) of

forward rates in the Vasicek model

df (t, T ) = e b(T t) drt + be b(T t) rt dt + be b(T t) dt drt

2
ae b(T t) dt +
1 e b(T t) e b(T t) dt
b
b(T t)
= e
((a brt )dt + dWt ) + be b(T t) rt dt

2
ae b(T t) dt +
1 e b(T t) e b(T t) dt
b
2
=
1 e b(T t) e b(T t) dt + e b(T t) dWt
b
Z T

2 b(T t)
b(st)
= e
e
ds dt + e b(T t) dWt
t
50 / 54
Hence df (t, T ) can be written as

df (t, T ) = (t, T )dt + (t, T )dWt
with
(t, T ) = e b(T t)
and
2 b(T t)
Z
(t, T ) = e
= e
b(T t)
Z
b(st)

ds
t
T
b(st)

ds
Z
= (t, T )
(t, s)ds
t
We note that the above relation between and is a not a

coincidence, but rather a general consequence of the absence of
arbitrage hypothesis on the dynamics of forward rates. This will be
elaborated in succeeding section.
51 / 54
Heath-Jarrow-Morton (HJM) condition

In the HJM model, the dynamics for the instantaneous forward rate is
given by
df (t, T ) = (t, T )dt + (t, T )dWt
where the date T is fixed. At this point, our objective is to determine
the conditions in which the above equation will make sense in the
financial context (that is, satisfying the absence of arbitrage
condition)
52 / 54
To determine this, we remark that at this point we have two different

formulas for bond prices
i
h RT
RT

P(t, T ) = e t f (t,u)du
and
P(t, T ) = EP e t ru du Ft
Both of these formulas should hold simultaneously so that there will
be absence of arbitrage.
This will ultimately yield the consistency relation between and ,
given by
Z T
(t, T ) = (t, T )
(t, s)ds
t
53 / 54
References
1
Bjork, Tomas. Arbitrage Theory in Continuous Time, 2nd

Edition. Oxford University Press, 2004.
Privault, Nicolas. An Elementary Introduction to Stochastic
Interest Rate Modelling. World Scientific Publishing Co. Pte.
Ltd, 2008
Brigo, Damiano and Mercurio, Fabio. Interest Rate Models Theory and Practice (with Smile, Inflation and Credit). Springer
Finance. Springer-Verlag, Berlin, 2006.
54 / 54

AMF 241 Interest Rate Models

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Bonds and Interest Rates

Bonds and Interest Rates

Bonds and Interest Rates

Bonds and Interest Rates

We will assume that there is an underlying probability space

Bonds and Interest Rates

Bonds and Interest Rates

Zero coupon bonds and related interest rates

Bonds and Interest Rates

Bonds and Interest Rates

Bonds and Interest Rates

Bonds and Interest Rates

Fix T ; P (t, T ) (as a function t) will be scalar stochastic process

Bonds and Interest Rates

Bonds and Interest Rates

We may now define a number of interest rates based on the zero

Bonds and Interest Rates

Bonds and Interest Rates

At time t we sell one S-bond. This will give us P(t, S) dollars.

Bonds and Interest Rates

Bonds and Interest Rates

At time T , the T -bonds mature at one dollar a piece, so we will

Bonds and Interest Rates

Bonds and Interest Rates

We now proceed to compute the relevant interest rates implied by

whereas the continuously compounded forward rate R is the solution

Bonds and Interest Rates

Bonds and Interest Rates

The simple forward rate for [S, T ] contracted at t, henceforth

Bonds and Interest Rates

Bonds and Interest Rates

The continuously compounded forward rate for [S, T ]

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

The continuously compounded spot forward rate, R(S, T ),

Bonds and Interest Rates

Bonds and Interest Rates

The instantaneous forward rate with maturity T , contracted

The instantaneous short rate at time T is defined by

Bonds and Interest Rates

Bonds and Interest Rates

Bonds and Interest Rates

Bonds and Interest Rates

The short rate of interest rt , is the (annualized) interest rate at which

Bonds and Interest Rates

Bonds and Interest Rates

Remark: One should note that in practice, the process rt is not

Bonds and Interest Rates

Bonds and Interest Rates

that is, it evolves according to the following initial value problem:

Bonds and Interest Rates

Bonds and Interest Rates

As an immediate consequence of the definitions we have the following

and for t s T , we have

Bonds and Interest Rates

Bonds and Interest Rates

Relations between df (t, T ), dP(t, T ) and dr (t)

Bond price dynamics

Forward rate dynamics

Bonds and Interest Rates

Bonds and Interest Rates

Bonds and Interest Rates

Bonds and Interest Rates

Bonds and Interest Rates

Bonds and Interest Rates