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InterestRate ReviewSheet

This document discusses interest rate times, volatility times, and the lognormal model for security price evolution over time. It contains the following key points: 1) Interest rates are expressed as simple rates for periods under one year and as zero-coupon rates for periods over one year. Volatility is measured by the standard deviation which grows with the square root of time. 2) The lognormal model uses random normal variables multiplied by the square root of time intervals to update security prices in a way that results in reasonable long-term behavior and matches observed outcome distributions. 3) An example shows how daily random normal variables multiplied by the volatility and square root of a day's interval can be compounded to model

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Dinh Ton
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74 views2 pages

InterestRate ReviewSheet

This document discusses interest rate times, volatility times, and the lognormal model for security price evolution over time. It contains the following key points: 1) Interest rates are expressed as simple rates for periods under one year and as zero-coupon rates for periods over one year. Volatility is measured by the standard deviation which grows with the square root of time. 2) The lognormal model uses random normal variables multiplied by the square root of time intervals to update security prices in a way that results in reasonable long-term behavior and matches observed outcome distributions. 3) An example shows how daily random normal variables multiplied by the volatility and square root of a day's interval can be compounded to model

Uploaded by

Dinh Ton
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Rate and Volatility Times - 1

Review Sheet: Interest Rate Time, Volatility Time, and


Exponential/Natural Log Functions
T
B bill/note/bond price in nominal terms of a zero coupon claim that matures at
time T, the current (spot) price, also bond/note/bill
T
PV .
T
R simple interest rate in nominal terms for funds invested or lent to time T. For
intervals T less than or equal to a year, the rate is a simple interest rate.
For intervals T greater than a year, the rate is on a periodic bond-equivalent
zero coupon basis.
T
Z Zero coupon continuously compounded interest rate for funds invested in
zero coupon bonds (strips) or borrowed in a zero coupon issue for maturity
T.
All other borrowed (short) and invested (long) bonds are aggregates of the
T
B s.
T < 1 year,
T
B =
( ) +
T
1
1 R * T
=
*
T
-Z T
e

Example =1%,
1
R
1
B =
( )

= =
+
=
1
0.0099503*1
1
1 0.01*
0.9901 e ,Z 0
1
.99503%
( )
=
T T T T
Given market R , solve for Z : Z ln 1+R T / T,
( )
=
T
Z
T
Z ln e , ln inverseof e
Continuous discounting is maximal. Given
T
B ,
T
Z <
T
R . Quoted rates drop as
compounding grows more frequent:
( )
= =
+
+
> =
1 1,2
2
1
1,2
1 1
,
1
1 R
1 R 2
B R R 0.9975%
,
( )

= = =
>
+
R Z
1, 1
n
1,
1
Lim
e e
n
1 R n

Analogous to compounding, borrowing or investment can be split into a current/spot
and forward component. For 1% six month and one year simple rates, a forward
six month rate into the remaining six months of the year is implied, :
1/2 1
R .
( ) ( ) ( )

= = =
+ + +
1/ 2 1/ 2 1 1
z 2 z 2 z
1 1/2 1/ 2 1
1 1 1
e e e
1 R 1 R 2 1 R 2

Solving
| | +
= =
|
+
\ .
1
1/ 2 1
1/ 2
1
0.9
R
2 1
1
95 ,
R 2
02% R ( ) = =
1/2 1 1/2 1
Z 2 ln 1+ R 2 0.992558%


Rate and Volatility Times - 2

Evolving, maturity T is broken up into n pieces, and h=T/n is each interval length. In
an interval, a normal random draw moves the price up or down. Volatility doesnt
grow with interest rate time, in t, but in the square root of time, t .
t h
v h
.
t h t h
S S e , v ~N(0,1)
+
o
+
=
This equation updates value in each interval.
Since we must take logs to standardize the relation, the type of value evolution is called log-normal:
( )
h 0 h h
Ln S S v h, v ~N(0,1). = o We use the square root because it matches the growth of risk/standard deviation
with reality, and because the formulation leads to the elegant Ito process for security prices. There are two logical
conditions needed for a successful process definition: 1) the series is reasonable over time, and 2) the value
outcomes at any maturity should match the observed distribution of outcomes:
For example, we have 10 normal observations a day for a year, and the first day v
h
s are :
{1.00643,0.38259,0.20658,0.73489,0.67623,0.79946,0.63541,0.75845,0.09569,0.58244}
Multiplying each observation by the 10% volatility, o=0.1, and the Sqrt[1/3600]=1/60 of the h interval, we raise e by this
power, for the daily capital gain loss factors:
{0.99832,0.99936,0.99966,1.00123,0.99887,0.99867,0.99894,0.99874,0.99984,1.00097}
We compound these daily factors for the value of the $1 in each of the 10 days:
{1.,0.99832,0.99769,0.99734,0.99857,0.99744,0.99611,0.99506,0.9938,0.99364,0.99461}
Random Normal, v
h

2 4 6 8 10
-1.0
-0.5
0.5

Value Sequence
2 4 6 8 10
0.995
0.996
0.997
0.998
0.999
1.000


One year of values
500 1000 1500 2000 2500 3000 3500
1.05
1.10
1.15

Five hundred such outcomes:
500 1000 1500 2000 2500 3000 3500
0.8
0.9
1.0
1.1
1.2
1.3
1.4




End of First Quarter (Black 900
intervals), and Year End (Blue
3600 Intervals) Outcomes

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