Académique Documents
Professionnel Documents
Culture Documents
and Investment
Dr. Ir. Budhi Arta Surya
September 21, 2010
The materials of this course are based on the references listed at the end of this slide.
Preliminary
Pt
Rt =
1.
Pt1
The simple gross return on the asset is 1 + Rt.
The assets multiyear gross return 1 + Rt (n) over recent n periods is defined by
Pt
Pt
Pt1
Pt2
Ptn+1
1 + Rt(n) :=
=
Ptn
Pt1
Pt2
Pt3
Ptn
= (1 + Rt ) (1 + Rt1) (1 + Rtn+1)
=
n1
Y
(1 + Rtj ).
j=0
h n1
i 1/n
Y
=
(1 + Rtj )
1.
j=0
Rta (n)
1X
Rtj .
n j=0
rt := log(1 + Rt ) = log
Pt
= pt pt1,
Pt1
where pt := log Pt .
n1
Y
(1 + Rtj ) =
j=0
n1
X
log(1 + Rtj ) =
j=0
n1
X
rtj .
j=0
Vt =
N
X
j=1
#j (t)Ptj Rtp =
N
X
j (t)Rtj ,
j=1
j
#j (t)Pt
.
Vt
rtp 6=
N
X
j (t)rtj .
j=1
The smallest net return achievable is 1 whereas the normal distributions support
is the entire real line. Hence, the lower bound of 1 is clearly violated.
If single-period returns are assumed to be normal, then multiperiod returns cannot
also be normal since they are the products of the single-period returns.
Log-Normal Distributional Properties
rit N (i , i ).
An Introduction to Capital Markets and Investment, SBM-ITB, August 2010
i +i2/2
E Rit = e
1
2i +i2
i2
e 1 .
Var Rit = e
(1)
The lognormal model has a long history dating back to the dissertation of Bachelier
(1900) and the work of Einstein (1905), containing the math of Brownian motion and
heat conduction. The model has underpinned the financial asset pricing theory.
Histogram of data
0.05
0.00
Sample Quantiles
log(Density)
15
0.15
0.10
10
Density
20
0.05
25
0.10
Asymm NIG
Gaussian
0.15
0.05
data
0.05
0.15
0.05
0.05
ghyp.data
0.15
0.05
0.05
0.15
Theoretical Quantiles
Figure 1: Histogram and density fits of Normal and NIG distributions to log-return of
CS data. Observe that the assumption on normality of the log-return is violated.
An Introduction to Capital Markets and Investment, SBM-ITB, August 2010
2 We refer to Bernstein (1992) and Lo (1996) for further literature study on the contributions of Bachelier, Cowles,
Samuelson, and many other early authors.
10
First, many researchers have tried to measure the profits earned by market
professionals such as mutual fund managers. If these managers achieve superior
returns (after adjustment for risk) then the market is not efficient with respect to
the information possessed by the fund managers.
This approach has the advantage that it concentrates on real trading by real
market participants.
But is has the disadvantage that one cannot directly observe the information
used by the managers in their trading strategies3.
Alternatively, one can ask whether hypothetical trading based on an explicitly
specified information set would earn superior returns. To implement this approach,
one must first choose an information set.
3 see Fama (1970,1991) for a thorough review of this literature.
11
According to Roberts (1967), the classic taxonomy of information sets can be divided
into three forms:
Weak-form Efficiency The information set includes only the history of prices or
returns themselves.
Semistrong-form Efficiency The information set includes all information known
to all market participants (publicly available information).
Strong-form Efficiency The information set includes all information known to any
market participant.
12
E X Ft = E E X Gt Ft
(2)
13
In other words, if one has limited information Ft, the best forecast one can make of a
random variable X is the forecast of the forecast one would make of X if one had
superior information Gt . The expression (2) can rewritten as
E X E X Gt Ft = 0,
(3)
which has an intuitive interpretation that one cannot use limited information Ft to
predict the forecast error one would make if one had superior information Gt .
Suppose that a security price at time t, Pt, can be written as the rational expectation
of some fundamental value V , conditional on information Ft available at time t,
Pt = E V
Ft .
The same reasoning applies to the security price Ps at time s > t, that is
Ps = E V Fs .
An Introduction to Capital Markets and Investment, SBM-ITB, August 2010
14
= Pt Pt
= 0.
Thus, realized changes in prices are unforecastable given information set Ft . From this
relatively elementary exercise we deduce martingale property of security prices:
E Ps Ft = Pt.
The essential passage behind the martingale concept is the notion of a fair game, a
game which is neither in the favor of an investor nor his/her opponents.
Alternatively, a game is fair if the expected incremental investment wealth at any
stage is zero when conditioned on the history of the game.
An Introduction to Capital Markets and Investment, SBM-ITB, August 2010
15
The notion of martingale has become a powerful tool and important applications
modern theories of asset prices - it has revolutionized the pricing of complex financial
instruments such as fixed income, options, swaps, and other derivative securities.
Needless to say, the martingale has become an integral part of every scientific
discipline concerning with asset model of asset prices: the random walk hypothesis.
Pt = + Pt1 + t,
where t IID(0, ),
(4)
where is the expected price change or drift, and IID(0, 2) denotes that t is
independently and identically distributed with mean 0 and variance 2.
An Introduction to Capital Markets and Investment, SBM-ITB, August 2010
16
E Pt P0 = P0 + t
2
Var Pt P0 = t.
(5)
It is apparent from (5) that the RW (4) is nonstationary and conditional mean and
variance are both linear in time.
Remarks The independence of the increments of {t} implies that the random
walk is also a fair game, but in a much stronger sense than the martingale:
Independence implies not only that increments are uncorrelated, but that any
nonlinear functions of the increments are also uncorrelated.
Perhaps the most common distributional assumption for the innovations or increments
t is normality. If t s are IID N (0, 2), then (4) is equivalent to an arithmetric
Brownian motion, sampled at regularly spaced unit intervals.
This distributional assumption simplifies many calculations, but violates the limited
liability condition: the price must be nonnegative. (If the conditional distribution of Pt
is normal, then there will always be a positive probability that Pt < 0.)
An Introduction to Capital Markets and Investment, SBM-ITB, August 2010
17
However, when natural logarithm of prices pt := log Pt follows a random walk with
normally distributed increments t, i.e.,
pt = + pt1 + t ,
the returns pts follow the lognormal model of Bachelier (1900) and Einstein (1905).
Pt = + Pt1 + t1t,
(6)
18
19
Rit = i + it
where E it
= 0 and Var it = 2 .
i
where Rit , the ith element of Rt , is the period-t return on security i, it is the
zero-mean disturbance term, and 2 is the (i, i) element of .
i
20
2. Market Model
The model is a statistical model which relates the return of any given security to the
return of the market portfolio. For any security i, the model is specified by
Rit = i +i Rmt + it
2
where E it = 0 and Var it = .
i
where
Rit and Rmt are the period-t returns on security i and the market portfolio,
respectively,
it is the zero-mean disturbance term,
In applications, a broad based stock index is used for the market portfolio, with the
S&P500 index, etc. (incl. CRSP value-weighted index, and the CRSP equal-weighted
index being popular choice.)
21
Ri = i + i Rm + i
(7)
(8)
where
22
1
bi = (Xi Xi) XiRi
2
i
b =
1 b b
i
(l 2) i
bi = Ri Xi bi
1 2
Var bi = (Xi Xi)
b
23
The Sharpe and Lintner derivations of the CAPM assume the existence of lending
and borrowing at a risk-free rate of interest. The Sharpe and Lintners CAPM model is
E Ri
= Rf + im E Rm Rf
(9)
Cov Ri , Rm
hRi, Rmi
im =
:=
(10)
hRm, Rmi
Var Rm
Define Zi := Ri Rf . Then, for the Sharpe and Lintners CAPM model we have
E Zi
= imE Zm
im
hZi , Zm i
hZm, Zmi
(11)
24
im
im
hRi , Rmi
hRm, Rmi
E Rom 1 im
7 This portfolio is defined to be the portfolio that has the minimum variance of all portfolios uncorrelated with m. (Any
other uncorrelated portfolio would have the same expected return, but a higher variance.)
25
investors behave so as to maximize the expected utility of their wealth at the end
of a single period.
investors choose among alternative portfolios according to expected return and
variance (or standard deviation) in return
borrowing and lending are unlimited and take place at an exogeneously determined
risk-free rate.
all investors share identical subjective estimates of the means, variances, and
covariances of return of all assets.
assets are completely divisible and perfectly liquid, with no transactions costs
incurred in their purchase or sale.
all investors are priced takers8, there are no taxes, and the quantities of all assets
are fixed.
8 in a perfectly competitive market, no individuals decisions to buy or sell will affect the market price; hence, individuals
must simply accept the market price when they trade.
26
R =
xp R := xp R, with xp 1 = 1.
j=1
Technical assumptions
Assume that returns are IID through time and jointly multivariate normal.
The expected returns of at least two assets differ
The covariance matrix := E RR is of full rank - invertible.
hRp, Rq i = xpxq .
An Introduction to Capital Markets and Investment, SBM-ITB, August 2010
27
L(x, 1, 2) := x x + 1 p x + 2 1 x 1
The first order Euler condition gives us the following system of equations
2x 1 21
(13)
(14)
(15)
x1
1
1
1
1
1 + 2 1.
2
2
(16)
28
1 1
1 1
1 1 +
1 1 2 =1
2
2
1 1
1 1
1 +
1 2 =p .
2
2
(17)
1
1
1
B 1 A
D
1
1
1
C A 1 ,
D
29
g is the minimum variance portfolio. op is the zero-beta portfolio w.r.t the portfolio
p, as this portfolio has a zero covariance with the portfolio p, i.e., hRop, Rpi = 0.
30
min xx,
x
subject to x + 1 x 1 Rf = p
(18)
L(x, ) := x x + p x 1 x 1 Rf .
Differentiating L w.r.t x and , we obtain
2x Rf 1
x + 1 x 1 Rf
(19)
(20)
p Rf = x Rf 1 .
An Introduction to Capital Markets and Investment, SBM-ITB, August 2010
(21)
31
1 1
Rf 1 .
2
(22)
(p Rf ) 1
=
Rf 1 ,
( Rf 1)
from which we finally have
xp =
(p Rf )
( Rf 1)1
1 Rf 1 .
Rf 1
Note that we can express xp as a scalar which depends on the mean of p times a
portfolio weight vector which does not depend on p, i.e.,
xp = Cpb
x.
An Introduction to Capital Markets and Investment, SBM-ITB, August 2010
32
33
Rf 1
.
xq = 1
1
Rf 1
1
(23)
With a risk-free asset, all efficient portfolios lie along the line from the risk-free asset
to the tangency portfolio, whose slope measures the market price of risk.
The tangency portfolio can be characterized as the portfolio with the maximum
Sharpe ratio of all portfolios of risky assets.
In the next section below we will derive the Sharpe-Lintner CAPM model (9).
An Introduction to Capital Markets and Investment, SBM-ITB, August 2010
34
2xmxm = xm Rf 1 = m Rf
1
=
m Rf 1
2xmxm
m Rf 1
2
2m
Rf 1 =
m Rf 1
2
m
xm.
ip
i Rf = 2 Rm Rf = i Rm Rf .
m
An Introduction to Capital Markets and Investment, SBM-ITB, August 2010
35
36
If an amount A (referred to as principal) is left in account at simple interest y , the value after n
years is V = (1 + yn)A.
If the proportional rule holds for fractional years, then after any time t (measured in years), the
account value is V = (1 + yt)A.
Compounding at various intervals The general method is that a year is divided into a fixed
number of equally spaced periods - say m periods. The interest rate for each of the m periods is
y
y mt
thus m
. Then after any time t (measured in years), the account value is (1 + m
) .
Continuous compounding To determine the yearly effect of continuous compounding, we use of
y mt
the fact that limm(1 + m
)
= eyt .
Debt: money borrowed from the bank will grow according to the same formulas.
Money market In reality there are many different rates9 each day applied to
different circumstances, different user classes, and different periods.
Examples: US Treasury bills and notes, LIBOR rate, Mortgage rate, inflation rate, etc.
9 Most rates are established by the forces of supply and demand in broad market to which they apply
37
n1
FV = x0 (1 + y) + x1 (1 + y)
+ ... + xn
.Example Consider the cash flow stream (2, 1, 1, 1) when the periods are years and
the interest rate is 10%. The future value is given by
3
x1
x2
xn
+
+
...
+
.
2
n
1+y
(1 + y)
(1 + y)
Example Consider the cash flow stream (2, 1, 1, 1). Using an interest rate of 10%,
PV = 2 +
1
1
1
+
+
= +0.487.
1.1
(1.1)2
(1.1)3
38
[Main theorem of internal rate of return] 10]. Let (x0 , x1 , ..., xn ) be cash flow
stream with x0 < 0 and xk 0 for all k, k = 1, 2, ..., n, with at least one term
being strictly positive. Suppose that there exist an internal rate of return y
satisfying 1/(1 + y ) = c. Then, it can be shown that c solves uniquely
2
(24)
Pn
Furthermore, if
k=0 xk > 0 (the total amount returned exceeds the initial
investment), then the internal rate of return y = 1/c 1 is strictly positive.
See equation (??) for further numerical discussion on solving equation (24).
10 See page 24 of Luenberger [4]
39
Taxes. If a uniform tax rate were applied to all revenues and expenses as taxes and
credits, respectively, then recommendations from before-tax and after-taxes analyses
would be identical.
Inflation is another economic factor that causes confusions, arising from the choice
between using actual dollar values to describe cash flows and using values expressed in
purchasing power, determined by reducing inflated future dollar values back to a
nominal level.
An Introduction to Capital Markets and Investment, SBM-ITB, August 2010
40
Inflation: Continued
rf
1+f .
41
We denote by P (t) the value at time zero of tbond, i.e., P (t) := P (0, t).
We impose the following assumption:
There exists a (frictionless) market for T bonds for every T > 0.
The relation P (t, t) = 1 holds for all t.
For each fixed t, the bond price P (t, T ) is differentiable w.r.t T .
[Remarks]
42
Borrow one unit of Sbond at time t and sell it to get $P (t, S).
Use the $P (t, S) cash to buy at time t P (t, S)/P (t, T ) units of T bonds.
At time S , the Sbond matures, so we have to pay back $1 at time S .
At time T , the T bonds mature and worth $P (t, S)/P (t, T ).
P (t, S)
P (t, T )
R(T S)
or e
P (t, S)
.
P (t, T )
43
Simple forward rate (LIBOR rate) for [S, T ] contracted at time t is defined as
L(t; S, T ) =
P (t, T ) P (t, S)
.
(T S)P (t, T )
Simple spot rate (LIBOR spot rate) for the period [S, T ] is defined as
L(S, T ) =
P (S, T ) 1
.
(T S)P (S, T )
(25)
log P (S, T )
.
(T S)
log P (t, T )
.
T
(26)
44
f 2 (u)du.
(27)
Z t
i
0
f (u)du = log Pi ,
for i = 1, 2, ..., m,
(28)
where Pi = P (ti), for i = 1, 2, ..., m, with P0 = 1, are given prices of discount bonds with
maturities 0 < t1 < t2 < ... < tm < T .
Using the Lagrange multipliers method, solution to the problem (27)-(28) is that
2
i1
45
PV =
n
X
P (ti )X(ti ) =
i=1
n
X
i=1
As the yield curve y(t) makes parallel shift of amount y for each t, i.e.,
ynew(t) = y(t) + y , the PV changes accordingly to
n
X
X
P V
y(ti )ti
=
ti e
X(ti ) =
ti P (ti )X(ti ).
y
i=1
i=1
Macaulay duration13 DX (of flows X )defined as the percentage change of PV, i.e.,
Pn
1 P V
ti P (ti )X(ti )
DX =
= Pi=1
.
(29)
n
PV y
P
(t
)X(t
)
i
i
i=1
Hence, Duration can also be seen as the PV-weighted average of time to maturity.
12 referring to the 1930 work of Macaulay.
13 Also known as the Fisher-Weil duration.
46
Examples of Duration
Consider a three-year 10% coupon bond with a face value of $100. Suppose that the
yield on the bond is 12% per annum with continuous compounding. This means that
y = 0.12. Coupon payments of $5 are made every six months.
Time (yrs)
0.5
1.0
1.5
2.0
2.5
3.0
Total
Payment ($)
5
5
5
5
5
105
130
Present Value
4.709
4.435
4.176
3.933
3.704
73.256
94.213
Weight
0.05
0.047
0.044
0.042
0.039
0.778
1.00
Time Weight
0.025
0.047
0.066
0.084
0.098
2.334
2.654
47
Security
Bond 1
Bond 2
Bond 3
Maturity
30
10
20
Price
69.04
113.01
100.00
Yield
9%
9%
9%
Duration
11.44
6.54
9.61
48
(30)
[Remarks]
The first equation states that the total value of the portfolio must equal the total
present value of the obligation.
The second equation states that the duration of the portfolio must equal the
duration (10 years) of the obligation.
The solution to the equation (30) is given by
49
W = X1 + X2.
The changes of the hedging portfolio to the parallel shift in the term structure of
interest rate can be written in terms of duration of each security as
W
X1
X2
= X1
+ X2
= X1 DX1 X2DX2 ,
y
X1 y
X2y
from which the amount of the hedging instruments to hold is given by
X1 DX1
X2 DX2
(31)
50
P (ti ) =
1
,
[1 + (y/m)]i1+x
Pn
Present Value
n
i
1 n h X (i 1 + x)
1
C
=
PV
m
[1 + (y/m)]i1+x
i=1
o
(n 1 + x)
F
+
m
[1 + (y/m)]n1+x
However, the formula doesnt measure the percentage change in PV for a small
change in the discrete yield to maturity, as explained further on the next page.
An Introduction to Capital Markets and Investment, SBM-ITB, August 2010
51
Modified Duration
Notice that the Macaulay duration is based on continuously compounded yield.
What happens to the percentage change in PV when the discrete yield to maturity
shifts from y to y + z for infinitely small changes in z ? Simple derivative of (??) gives
Modified Duration =
1 P V
PV y
n
i
1 n h X (k 1 + x)
1
=
C
PV
m
[1 + (y/m)]k+x
k=1
o
(n 1 + x)
1
+
m
[1 + (y/m)]n+x
=
Conventional Duration
.
1 + (y/m)
The two formulas are the same for continuous compounding yield.
In terms of the hedge ratio, see eqn. (31), the modified duration may induce hedging
error if the bond to be hedged and the hedging instrument have different amounts of
accrued interest. This impact is known as the accrued interest rate effect.
The impact is obviously most significant when the yield curve has a significant slope.
An Introduction to Capital Markets and Investment, SBM-ITB, August 2010
52
The duration only measures the linear relationship between the percentage change
P/P in present value and change y in yield of a bond portfolio.
For large yield changes, the portfolio may behave differently as the relationship may
not be linear. A factor known as convexity measures this curvature and can therefore
be used to improve the relationship in (29).
An Introduction to Capital Markets and Investment, SBM-ITB, August 2010
53
1 2P V
=
=
2
PV y
Pn 2
ti P (ti )X(ti )
Pi=1
.
n
i=1 P (ti )X(ti )
(32)
dP
1 d2 P
2
P =
y +
(y)
dy
2 dy 2
1
= DP y + CP (y)2 .
2
By matching convexity as well as duration, a portfolio can be made immune to
relatively large parallel shifts in the curve. However, it is exposed to nonparallel shifts.
54
Pn,t
1
=
,
(1 + Yn,t )n
(33)
(1 + Yn,t) = Pn,t
(34)
Taking the natural algorithm on both sides of the above equation, we have
1
yn,t = pn,t .
n
(35)
The term structure of interest rates is the set of YTMs, at a given time, on bonds of
different maturities. The yield curve is a plot of the term structure, that is the plot of
Yn,t or yn,t against n on some particular date t.
An Introduction to Capital Markets and Investment, SBM-ITB, August 2010
55
Yield-to-Maturity
18
16
14
10year yield
12
10
8
6
4
1month yield
2
0
1950
1955
1960
1965
1970
1975
1980
1985
1990
1995
56
Holding-Period Returns
The holding-period return on a bond is the return over some holding period less than
the bonds maturity. Define Rn,t+1 as the one-period holding-period return on an
nperiod bond purchased at time t and sold at time t + 1, i.e.,
(1 + Yn,t)n
Pn1,t+1
=
.
(1 + Rn,t+1 ) =
Pn,t
(1 + Yn1,t+1 )n1
(36)
Remarks The holding period-return (36) is high if the bond has a high yield when it is
purchased at time t, and if it has a low yield when it is sold at time t + 1.
Taking the logs, the log holding-period return, rn,t+1 := log(1 + Rn,t+1 ), is given by
rn,t+1
pn1,t+1 pn,t
nyn,t (n 1)yn1,t+1
(37)
(38)
Following (37), we obtain a relation between log bond prices and log holding-period
An Introduction to Capital Markets and Investment, SBM-ITB, August 2010
57
return as pn,t =
P n1
i=0
yn,t
1X
=
rni,t+1+i,
n i=0
showing that the log YTM on a zero-coupon bond equals the average log return per
period if the bond is held to maturity.
Forward Rates
The forward rate is defined to be the return on the time t + n investment of
Pn+1,t/Pn,t , i.e.,
1
(1 + Yn+1,t )n+1
(1 + Fn,t) =
=
.
n
(Pn+1,t /Pn,t )
(1 + Yn,t )
Moving to the logs scale, the nperiod ahead log forward rate is
fn,t
pn,t pn+1,t
(39)
58
(40)
where the stochastic process Lt , known as the stochastic discount factor for
transforming the pricing kernel from P to Q, is defined by
dQ
Lt :=
dP Ft
The equation (40) lends itself to the recursive equation for the nperiod ZC bond:
Pn,t = Et Lt+1 . . . Lt+n .
1
+ Vart lt + pn,t .
2
(41)
59
1
pn,t = Et lt+1 + pn1,t+1 + Vart lt+1 + pn1,t+1 ,
2
(42)
pn,t = An + Bnxt
(43)
for all n = 0, 1, . . . . Since the nperiod bond yield yn,t = pn,t/n, we are
guessing that the yield on a bond of any maturity is linear or affine in xt .
We already know that the bond price for n = 0 and n = 1 satisfy the equation (43),
with A0 = B0 = 0, A1 = 2 2/2, and B1 = 1. We proceed with our guess using
the induction methodology- showing that it is consistent with the pricing relation (42).
60
lt+1 = xt + t+1 ,
(44)
with t+1 being an innovation process normally distributed with constant variance.
The model is a discrete-time version of the Vasicek single-factor term structure model.
The model assumes that the macro factors xt evolves according to a univariate AR(1)
process with mean and persistence 15,
xt+1 = (1 ) + xt + t+1 .
(45)
The innovations t+1 may be correlated with t+1 . To capture this, we can write
61
t+1 = t+1 .
The equation (44) can therefore be rewritten as
lt+1 = xt + t+1 .
(46)
62
1
2 2
p1,t = Et lt+1 + Var lt+1 = xt + /2.
2
(47)
y1,t = xt /2.
Remarks:
The short rate equals the state variable less a constant term, so it inherits the AR(1)
dynamics of the state variable. So, we can think of the short rate as measuring the
state of the economy in this model. Notice that there is nothing in (47) that rules out
a negative short rate.
An Introduction to Capital Markets and Investment, SBM-ITB, August 2010
63
An
1
( + Bn1)2 2 = 0.
2
As this must hold for any xt , so the coefficients on xt must sum to zero and the
remaining coefficients must also sum to zero. This implies that
Bn
An
(1 n)
=
(1 )
1 + Bn1
1 2
2
An1 + (1 )Bn1 ( + Bn1) ,
2
(49)
64
lt+1
xt+1
xt t+1 = xt + xt t+1
(1 ) + xt + xt t+1 .
xt +
(50)
(51)
65
xt .
Proceeding with the recursive analysis as before, we can determine the price of a
one-period bond by substituting (50) into (42) to get
p1,t
1
2 2
Et lt+1 + Vart lt+1 = xt 1 /2 .
2
(52)
As we can see, the one-period bond yield y1,t = p1,t is proportional to the state
variable xt ; the short rate measures the state of the economy in the model.
Since the short rate is proportional to the state variable, it inherits the property that
its conditional variance is proportional to its level16. As a result, interest rate volatility
tends to be higher when interest rates are high.
This property makes it difficult for the interest rate to go negative, since the upward
drift in the state variable tends to dominate the shocks as xt declines towards zero.
16 implying the risk premia to be time-varying.
66
pn,t = An + Bnxt
with A0 = B0 = 0, A1 = 0, and B1 = 1 2 2 /2.
It is straightforward to show that
2
Bn
An
An1 + (1 )Bn1.
(53)
Remarks:
Comparing (53) to (49), we see that the term in 2 has been moved from the
equation describing An to the equation describing Bn. This is due to the fact that
the variance is now proportional to the state variable, so that it affects the slope
coefficient rather than the intercept coefficient for the bond price. The slope
coefficient Bn is positive and increasing in n.
An Introduction to Capital Markets and Investment, SBM-ITB, August 2010
67
x1,t+1
x2,t+1
x1,t 1,t+1
(1 1 )1 + 1 x1,t +
(55)
(56)
t+1 = 1,t+1
meaning that the variance of the innovation to the log SDF is proportional to the level
of x1,t . The log SDF is conditionally correlated with x1,t but not with x2,t .
An Introduction to Capital Markets and Investment, SBM-ITB, August 2010
68
p1,t
1
+ Vart lt+1
2
Et lt+1
(57)
2
(58)
We observe that the one-period bond yield y1,t = p1,t is no longer proportional to
the state variable x1,t as it also depends on 2,t. Said differently, the short rate is no
longer sufficient to measure the state of the economy in this model.
As pointed out by Longstaff and Schwartz, the variance of the short rate is a different
linear combination of the two state variables:
2 2
2 2
2
Vart y1,t+1 = (1 1 /2) 1 x1,t + 2 x2,t .
An Introduction to Capital Markets and Investment, SBM-ITB, August 2010
69
(59)
B1,n
(60)
B2,n
(61)
An
(62)
70
6.4
Mean Yield
6.2
5.8
5.6
twofactor model
onefactor model
bond yields data
5.4
10
20
30
40
50
60
70
Maturity in Months
80
90
100
110
120
Figure 6: Fitting single-factor and two-factor term structure models to real data.
An Introduction to Capital Markets and Investment, SBM-ITB, August 2010
71
72
P (T, r; T ) = 1.
[Short Rate Dynamics] We assume that the dynamics of short rate r(t) is driven by
the following stochastic differential equations (SDE):
(63)
73
dB(t)
dt
dB(t)
dt
0
dt
0
0
(64)
74
2
2
(dX(t))2 = 2 (t, X(t)) dt + 2(t, X(t)) dB(t)
+ 2(t, X(t))(t, X(t)) dtdB(t)
= 2(t, X(t))(dB(t))2
2
= (t, X(t))dt.
Simulating Stochastic Differential Equations
Assume that we are given a stochastic differential equation (SDE) of the form
75
Itos formula
Theorem 1. [It
os Formula] Assume that the process X solves the following SDE
dP =
1 2
Pt + (t, x)Px + (t, x)Pxx dt + (t, x)Px dB(t).
2
(65)
[Heuristic proof] Applying the Taylor expansion including second order terms, we have
1
1
2
2
dP = Pt dt + PxdX + Pxx(dX) + Ptt (dt) + Ptx(dtdX).
2
2
The result in (65) is obtained after applying the multiplication rules (64).
An Introduction to Capital Markets and Investment, SBM-ITB, August 2010
76
Dynamics of T bond
Consider a hedging portfolio V consisting of T bond and Sbond, i.e.,
T
(66)
Assume that the hedging strategy (t) is predictable17, and the short rate r(t) follows
(63) so that by (65) the dynamics of the T bond price P T (t, r) can be written as
dP T
PT
T (t)dt + T (t)dB(t),
T 1
T
Pt
T (t)
(P )
T (t)
(t, r)(P )
T 1
T
(t, r)Pr
(67)
1 2
T
+ (t, r)Prr ,
2
Pr .
(68)
(69)
Likewise for Sbond. By inserting (67) and the corresponding equation for Sbond,
dV (t) =
T
S
T (t)P (t) + (t)S (t)P (t) dt
T
S
+ T (t)P (t) + (t)S (t)P (t) dB(t).
(70)
17 that is to say (t) = (t + dt) - the hedging strategy for the period of time [t, t + dt) has been specified at time t.
77
PrT
T (t)P T (t)
(t) =
= S
S (t)P S (t)
Pr
for all t 0
(71)
for all t 0,
S (t) r(t)
T (t) r(t)
=
S (t)
T (t)
for all t 0 .
(72)
Remark Notice that the two quotients are equal regardless of the choice of the bond18.
18 It is the fixed income equivalent of the Sharpe ratio.
78
T (t) r(t)
= (t).
T (t)
(73)
Furthermore, by inserting the expressions (68) and (69) for T and T , respectively,
we obtain a so-called the term structure equation (TSE) given in the eqn. (74) below.
Proposition 2. Assume that the short rate evolves according to (63). If the bond
market is free of arbitrage, then the price of the T bond P T solves the TSE:
PtT
1
T
+ PrT + 2Prr
rP T = 0
2
(74)
P T (T, r) = 1.
In order to solve the term structure equation, we must specify the market price of risk
as well as the drift and and the volatility of the short rate (63).
An Introduction to Capital Markets and Investment, SBM-ITB, August 2010
79
P (t, r; T ) = E
R
tT r(u)du
e
P (T, r; T ) Ft ,
(75)
where Q is a risk-neutral pricing measure under which the dynamics of short rate is
80
P (t, r; T ) = e
Proposition 4.
(76)
Assume that the drift and the volatility of r are of the form
(77)
Then, the T bond price has the form (76) where the functions F and G solve
1
2
Gt (t, T ) + (t)G(t, T ) (t)G (t, T ) = 1, G(T, T ) = 0,
2
1
Ft(t, T ) (t)G(t, T ) + (t)G2 (t, T ), = 0, F (T, T ) = 0.
2
An Introduction to Capital Markets and Investment, SBM-ITB, August 2010
(78)
81
dr(t) = dB(t).
(79)
Following the TSE (74), the T bond price solves the following equation:
1
Pt Pr + 2Prr rP = 0,
2
P (T, r; T ) = 1
After some tedious calculations, it turns out that the solution to this PDE is
r + 2/2+1/6 2a 3
P (t, r; T ) = P (, r) = e
= T t.
82
Hedge ratio
The hedge ratio of the hedging portfolio is given by
(T t)P (t, r; T )
.
(S t)P (t, r; S)
Yield curve
For continuous compounding, the ZC bond yield implied by the model is
1
1
1 2 2
y( ) = ln P (, r) = r .
2
6
Remarks
3
The yield achieves its maximum value r + 38 2 at = 2
.
q
2
3
3
The yield equals zero at = 2 + 4 + 2r
3.
83
P (t, r; T ) = e
(80)
Z T
t
(s)(s T )ds +
(T t)3 +
(T t)2 (81)
6
2
2
1
y(t, T ) = r
(T t)
(T t)2
2
6
(T t)
T
t
The function (t) is chosen such that the theoretical zero-coupon bond prices at
t = 0 (P (0, T ); T 0) fits the observed initial term structure (P (0, T ); T 0).
We thus want to find (t) such that P (0, T ) = P (0, T ) for all T 0.
An Introduction to Capital Markets and Investment, SBM-ITB, August 2010
84
0.07
r(t)
0.06
0.05
0.04
0.03
0.02
10
Time
In his 1977 work, Vasicek proposed a model that avoids the certainty of having
negative yields in the Merton model of term structure, which is of the form
(83)
85
When rates are high, the economy tends to slow down as there is low demand for
fund from borrowers, which results in declining rates.
When rates are low, there is a high demand for funds from borrowers, resulting
increasing in rates.
When rates rise above the expected long-term rate , the rates is pulled back below
at the speed , vice versa.
Exercise Show using It
os formula that solution to the Vasicek model (83) is
t
r(t) = + e
r0 + e
dB(u) .
(84)
r(t) N + e
2
2t
(r0 ),
1e
.
2
(85)
86
1 2
Pt + ( r) Pr + Prr rP = 0,
2
P (T, r; T ) = 1.
(86)
P (, r) = eF ( )G( )r ,
where = T t. By inserting this in (86), the functions f and g are found to be
1
G( ) =
1e
2
2G2 ( )
F ( ) = +
G( )
.
2
2
4
87
Hedge ratio
The hedge ratio of the hedging portfolio is given by
=
Yield curve
Remark
1
2
y( ) =
f ( ) + g( )r
y() = +
.
|{z}
2
2
as
The duration and hedge ratio under the Merton model can be seen as the limit of
the Vasicek models as the speed of mean reversion tends to zero.
The yield is positive at perpetual time, correcting one of major concern of the
Merton term structure model (79).
Since the short rate r(t) is normally distributed, see equation (85), there is a
positive probability that the short rate r(t) can become negative.
An Introduction to Capital Markets and Investment, SBM-ITB, August 2010
88
The parameters a and are typically chosen to obtain a nice volatility structure,
whereas the function (t) is chosen such that the theoretical zero-coupon bond prices
at t = 0 (P (0, T ); T 0) fits the observed initial term structure (P (0, T );
T 0). We thus want to find (t) such that P (0, T ) = P (0, T ) for all T 0.
R
2G2 (s,T )(s)G(s,T ) ds
G(t,T )r(t)+ tT 1
2
,
(87)
P (t, T ) = e
where the function G(t, T ) is defined as
1
a(T t)
G(t, T ) =
1e
.
a
An Introduction to Capital Markets and Investment, SBM-ITB, August 2010
89
P (, r) = eF ( )G( )r ,
(88)
F ( ) =
2
ln
2
2e(++) /2
H( )
G( ) =
2 1 e
H( )
,
90
H( ) = 2 + + + e 1
q
= ( + )2 + 2 2.
The Longstaff model
dr(t) =
r(t) dt +
r(t)dB(t).
The model results in a complex function for the ZC bond price of the form
F ( )+G( )r+H( ) r
P (, r) = e
Longstaff argues that the non-linearity of the yield curve implied by the model does
bring extra explanatory power to the model.
However, the pricing of even intermediate term discount bond can be more
complex than can be accommodated within the context of one factor model.
An Introduction to Capital Markets and Investment, SBM-ITB, August 2010
91
As the model is quite complicated to get a closed form expression for the price of ZC
bond, Black and Karasinski used lattice approach.
92
where p the target value of ln r relative to the level of ln , and is the consol rate,
2
d(t) = (t) (t) r(t) + 2 + 22 dt + 2(t)dB2(t).
93
dr(t)
d(t)
d(t)
94
f (t, T ) =
log P (t, T ),
T
(89)
we may bridge the gap between the theoretical forward rate curve (f (0, T ); T > 0)
and to the observed forward rate curve (f (0, T ); T > 0), where f is defined
f (0, T ) = r0 +
T
0
2 2
(s)ds
T T.
2
(t) =
f (0, t) + 2t + .
T
(90)
95
allowing us to use partial differential equations (PDE) to get the price of ZC bond.
allowing us to get analytical formulas for the bond prices, etc.
The main drawbacks of the short rate models:
from the view point of economics, it seems unreasonable to assume that the entire
money market is governed by only one state variable.
it is hard to get a realistic volatility structure for the forward rates without
introducing a very complicated short rate model.
the inversion of yield curve (through the concept of parallel shift of the yield) as
discussed before becomes increasingly more difficult to get a realistic one.
An Introduction to Capital Markets and Investment, SBM-ITB, August 2010
96
In the section where we discuss the calibration of Ho and Lee model to the terms
structure data, we find it more convenient to work with forward rate.
[Assumption] Assume that for every fixed T > 0, the forward rate f (t, T ) follows
Z t
Z t
(91)
f (t, T ) = f (0, T ) +
(s, T )ds +
(s, T )dB(s)
0
The Proposition 5 below provides condition on the drift of the forward rate model
(91) so that the price of ZC bond under the forward rate model
P (t, T ) =
R
tT f (t,u)du
e
,
(92)
(t, T ) = (t, T )
(t, s)ds
(93)
97
(t) =
2
f (0, t) + t.
T
As discussed earlier, this model perfectly fits the initial term structure. See eqn (90).
An Introduction to Capital Markets and Investment, SBM-ITB, August 2010
98
r(t) N + e
2
2t
(r0 ),
1e
.
2
(94)
There are many approaches in doing so. Below are some of them.
r = a + br + .
b
a
= bb and = .
bb
99
y( ) = f ( ) + g( )r,
where g( ) =
(1e )
,
Var(y( )) = g ( )Var(r).
Find the best fitting values of and that best fit the yield volatilities.
100
101
102
there are no transaction costs, and that assets can be divided arbitrarily.
Also, we assume initially that it is possible to store the underlying asset without
cost and it is possible to sell short.
Later we will allow for storage cost, but still require that it be possible to store the
underlying asset for the duration of the contract20.
Illustration Suppose we buy one unit of the commodity at price S on the spot market
and simultaneously enter a forward contract to deliver at time T one unit at price F .
We store the commodity until T and deliver it to meet our obligation and obtain F .
This must be consistent with the interest rate between t = 0 and t = T . Hence,
S = B(0, T )F
In other words, because storage is costless, buying the commodity at price S is exactly
the same as lending an amount S of cash for which we will receive an amount F at T .
20 This is a good assumption for many assets, such as gold or sugar, or T bills, but perhaps not good for perishable
commodities such as oranges.
103
At t = 0
Borrow $S
Buy one unit and store
Short one forward
Total
Initial Cost
-S
S
0
0
Final Receipt
-B 1 (0, T )S
0
F
F B 1 (0, T )S
104
At t = 0
Lending $S
Short one unit
Go long one forward
Total
Initial Cost
S
-S
0
0
Final Receipt
B 1(0, T )S
0
-F
B 1(0, T )S F
Our profit is B 1(0, T )S F (which we might share with the asset lender for
making the short possible).
Since either inequality leads to an arbitrage opportunity, equality must hold. 2
105
ft = (Ft F0)B(t, T ),
where B(t, T ) is the risk-free discount factor over the period from t to T .
Proof. Construct the following portfolio at time t. One unit long of a forward
contract with delivery price Ft maturing at time T , and one unit short of the contract
with delivery price F0. The initial cash flow of this portfolio is ft . The final cash flow
at time T is F0 Ft. The present value of this portfolio is ft + (F0 Ft)B(t, T ),
and this must be zero, otherwise arbitrage opportunity exists. 2
106
Futures Contract
Like the forward contract, a futures contract is an agreement between two parties to
buy or sell an asset at a certain time in the future for a certain price.
Unlike forward contracts, futures contract are normally traded on an exchange. To
make trading possible, the exchange specifies certain standardized features of the
contract. The buyer and seller do not necessarily know each other. The exchange
provides a mechanism that gives the two parties a guarantee that the contract will be
honored.
Because forward trading is so useful, it became desirable long ago to standardized the
contracts and trade them on an organized exchange.
However, standardization of forward prices is impossible. To see this. Suppose that
contracts were issued today at a delivery price of F0. The exchange would keep track
of all such contracts. Then tomorrow the forward price might change and contracts
initiated that day would have a different delivery price F1. In fact, the appropriate
delivery price might change continuously throughout the day. The thousands of
outstanding forward contracts could each have a different delivery price, even though
all other terms were identical. This would be a bookkeeping nightmare.
An Introduction to Capital Markets and Investment, SBM-ITB, August 2010
107
108
The
The
The
The
The
The
109
c S0
and
C S0
pK
and
P K.
max(S0 KerT , 0)
max(KerT S0 , 0)
To prove this inequality for call option, consider the following two portfolios:
rT
110
At the expiration date, both portfolios are worth at max(ST , K). This means that
rT
c + Ke
= p + S0.
If the inequality does not hold, then there would be an arbitrage opportunity.
Relationship Between American Put and Call Options
It can be shown using no arbitrage opportunity strategy that
rT
S0 K C P S0 Ke
An Introduction to Capital Markets and Investment, SBM-ITB, August 2010
111
112
cu = max(uS K, 0);
cd = max(dS K, 0),
can be replicated by a portfolio consisting of stock and bond each of which is worth x
and y dollars according to
ux + Ry = cu
and dx + Ry = cd.
cu cd
x=
ud
ucd dcu
and y =
.
R(u d)
(95)
Using the no-arbitrage argument, the value of the European call option c is therefore
equal to the value of the portfolio x + y , i.e.,
1
c=x+y =
qcu + (1 q)cd ,
R
An Introduction to Capital Markets and Investment, SBM-ITB, August 2010
Rd
where q =
.
ud
(96)
113
c=
1
qcu + (1 q)cd ,
R
where q =
Rd
.
ud
(97)
1 Q
c(T 1) = E c(T ) .
R
Remarks
The equation (97) states that the call option value c is found by taking the
expected value of the option under the risk-neutral probability q .
This procedure of valuation works for all securities, including the underlying stock
S=
1
quS + (1 q)dS
R
(98)
114
q=
Rd
.
ud
The values of cu and cd are found using the single-period calculation given earlier:
cu
cd
1
qcuu + (1 q)cud
R
1
qcud + (1 q)cdd
R
1
qcu + (1 q)cd
c=
R
(99)
116
where S0 is the initial stock price and ST is the price at the end of year 1. Likewise,
we define as the yearly standard deviation, i.e.
2 = Var ln(ST /S0 ) .
If the period time length t small enough compared to 1, the parameters of the
binomial lattice can be selected as
1
1
p =
+
t
(100)
2
2
u
d
=
=
(101)
(102)
118
119
Rd+c
q=
,
ud
ucR
and 1 q =
.
ud
120
dS = Sdt + dW (t),
(103)
where W is the standard Brownian motion. Suppose also that there is a risk-free
zero-coupon bond carrying an interest rate of r over the period [0, T ] with
dB = rBdt.
(104)
Let C(S, t) denote the price of the option at time t when the stock price is S . This
function solves the famous Black-Scholes formula.
Theorem 5. Suppose that the price of an asset is governed by (103) and the
risk-free interest rate is r . A derivative of this security has a price C(S, t) satisfying
the PDE:
C
C
1 2C 2 2
+
rS +
S rC = 0.
(105)
2
t
s
2 s
Solution to this equations is given by the renowned Black-Scholes-Merton model:
An Introduction to Capital Markets and Investment, SBM-ITB, August 2010
121
C(S, t)
d1
d2
ln S/K) + (r + 2/2)(T t)
T t
p
d1 T t
122
123
Main References
References
[1] Bjork, T. Arbitrage Theory in Continuous Time, Oxford University Press, 2004.
[2] Campbell, J, Y., Lo, A. W and MacKinlay, A. C. The Econometrics of Financial
Markets, Princeton University Press, 1997.
[3] Hull, J. Options, Futures, And Other Derivatives, Sixth Edition, Pearson
Prentice Hall, 2006.
[4] Luenberger, D. Investment Science, Oxford University Press, 1998.
[5] Van Deventer, D. R., Imai, K., and Mesler, M. Advanced Financial Risk
Management: Tools and Techniques for Integrated Credit Risk and Interest
Rate Risk Management, Willey, 2005.
[6] Martin, J. D., Cox, Jr. S. C., and MacMinn, R. D. The Theory of Finance:
Evidence and Application, The Dryden Press, 1988.
124