CHAPTER 6

Two-Factor Short-Rate Models

6.1. G2++ Model

Remark 6.1 (Motivation). In an ane term-structure model, f (t, T1 ) and

f (t, T2 ) with T1 = t + 1 and T2 = t + 100 (short and long rate) are perfectly
correlated, i.e., their correlation coecient is one, which is not realistic.

Definition 6.2 (Short-rate dynamics in the G2++ model). In the G2++ model,
the short rate is given by

r(t) = x1 (t) + x2 (t) + (t),

where is deterministic and x1 and x2 are assumed to satisfy the stochastic prob-
lems
dx1 (t) = k1 x1 (t)dt + 1 dW1 (t), x1 (0) = 0

and
dx2 (t) = k2 x2 (t)dt + 2 dW2 (t), x2 (0) = 0,

where k1 , k2 , 1 , 2 > 0 and W1 and W2 are Brownian motions under the risk-
neutral measure such that

dW1 (t)dW2 (t) = dt with [1, 1].

Theorem 6.3 (Short rate in the G2++ model). Let 0 s t T . The short
rate in the G2++ model is given by

r(t) = x1 (s)ek1 (ts) + x2 (s)ek2 (ts) + (t)

 t  t
+1 ek1 (tu) dW1 (u) + 2 ek2 (tu) dW2 (u)
s s

and is, conditionally on F(s), normally distributed with

E(r(t)|F(s)) = x1 (s)ek1 (ts) + x2 (s)ek2 (ts) + (t)

33
34 6. TWO-FACTOR SHORT-RATE MODELS

and

12   2  
V(r(t)|F(s)) = 1 e2k1 (ts) + 2 1 e2k2 (ts)
2k1 2k2
21 2  
+ 1 e(k1 +k2 )(ts) .
k1 + k2

Theorem 6.4 (Zero-coupon bond in the G2++ model). In the G2++ model,
the price of a zero-coupon bond with maturity T at time t [0, T ] is given by
  
T
1 2
P (t, T ) = exp (u)du M (t, T ) + V (t, T ) ,
t 2

where

M (t, T ) = x1 (t)B1 (t, T ) + x2 (t)B2 (t, T )

and
 
12 k1 2
V 2 (t, T ) = T t B1 (t, T ) B1 (t, T )
k12 2
 
22 k2 2
+ T t B 2 (t, T ) B (t, T )
k22 2 2
21 2
+ (T t B1 (t, T ) B2 (t, T ) + B12 (t, T )) ,
k1 k2

where
1 ek1 (T t) 1 ek2 (T t)
B1 (t, T ) = , B2 (t, T ) = ,
k1 k2
and
1 e(k1 +k2 )(T t)
B12 (t, T ) = .
k1 + k2

Theorem 6.5 (Forward rate in the G2++ model). In the G2++ model, the
instantaneous forward rate with maturity T is given by

f (t, T ) = (T ) + x1 (t)ek1 (T t) + x2 (t)ek2 (T t)

12 2 2
B1 (t, T ) 2 B22 (t, T ) 1 2 B1 (t, T )B2 (t, T ).
2 2

Theorem 6.6 (Calibration in the G2++ model). If the CIR2++ model is cal-
ibrated to a given interest rate structure {f M (0, t) : t 0}, then

12 2 2
(t) = f M (0, t) + B1 (0, t) + 2 B22 (0, t) + 1 2 B1 (0, t)B2 (0, t).
2 2
 6.1. G2++ MODEL 35

Theorem 6.7 (Zero-coupon bond in the calibrated G2++ model). If the G2++
model is calibrated to a given interest rate structure, then

P M (0, T ) 1
2 
P (t, T ) = M exp V (t, T ) V 2 (0, T ) + V 2 (0, t) M (t, T ) ,
P (0, t) 2
where M and V 2 are given in Theorem 6.4.

Theorem 6.8 (Bond-price dynamics in the G2++ model). In the G2++ model,
the price of a zero-coupon bond with maturity T satises the stochastic dierential
equations

dP (t, T ) = r(t)P (t, T )dt 1 B1 (t, T )P (t, T )dW1 (t) 2 B2 (t, T )P (t, T )dW2 (t)

and
1 12 B12 (t, T ) + 22 B22 (t, T ) + 21 2 B1 (t, T )B2 (t, T ) r(t)
d = dt
P (t, T ) P (t, T )
1 B1 (t, T ) 2 B2 (t, T )
+ dW1 (t) + dW2 (t).
P (t, T ) P (t, T )

Theorem 6.9 (T -forward measure dynamics of the short rate in the G2++
model). Under the T -forward measure QT , the short rate r in the G2++ model
satises r(t) = x1 (t)+x2 (t)+(t) such that x1 and x2 are solutions of the stochastic
dierential equations


dx1 (t) = 12 B1 (t, T ) + 1 2 B2 (t, T ) + k1 x1 (t) dt + 1 dW1T (t)

and


dx2 (t) = 22 B2 (t, T ) + 1 2 B1 (t, T ) + k2 x2 (t) dt + 2 dW2T (t),

where the QT -Brownian motions W1T and W2T are dened by

dW1T (t) = dW1 (t) + (1 B1 (t, T ) + 2 B2 (t, T )) dt

and
dW2T (t) = dW2 (t) + (2 B2 (t, T ) + 1 B1 (t, T )) dt.

Theorem 6.10 (Forward-rate dynamics in the G2++ model). In the G2++

model, the instantaneous forward interest rate with maturity T satises the sto-
chastic dierential equation

df (t, T ) = 1 ek1 (T t) dW1T (t) + 2 ek2 (T t) dW2T (t).

36 6. TWO-FACTOR SHORT-RATE MODELS

Theorem 6.11 (Forward-rate dynamics in the G2++ model). In the G2++

model, the simply-compounded forward interest rate for the period [T, S] satises
the stochastic dierential equation
 
1
dF (t; T, S) = 1 F (t; T, S) + (B1 (t, S) B1 (t, T ))dW1S (t)
(T, S)
 
1
+2 F (t; T, S) + (B2 (t, S) B2 (t, T ))dW2S (t).
(T, S)

Theorem 6.12 (Option on a zero-coupon bond in the G2++ model). In the

G2++ model, the price of a European call option with strike K and maturity T and
written on a zero-coupon bond with maturity S at time t [0, T ] is given by

ZBC(t, T, S, K) = P (t, S)(h) KP (t, T )(h

),

where

12   2  
2
= 1 e2k1 (T t) B12 (T, S) + 2 1 e2k2 (T t) B22 (T, S)
2k1 2k2
+21 2 B1 (T, S)B2 (T, S)B12 (t, T )

and
 
1 P (t, S)

h= ln + .

P (t, T )K 2
The price of a corresponding put option is given by

ZBP(t, T, S, K) = KP (t, T )(h +

) P (t, S)(h).

Theorem 6.13 (Caps and oors in the G2++ model). In the G2++ model, the
price of a cap with notional value N , cap rate K, and the set of times T , is given
by

Cap(t, T , N, K) = N [P (t, Ti1 )(hi +
i ) (1 + i K)P (t, Ti )(hi )] ,
i=+1

while the price of a oor with notional value N , oor rate K, and the set of times
T , is given by

Flr(t, T , N, K) = N [(1 + i K)P (t, Ti )(hi ) P (t, Ti1 )(hi
i )] ,
i=+1
 6.1. G2++ MODEL 37

where

12  
2
= 1 e2k1 (Ti1 t) B12 (Ti1 , Ti )
2k1
2  
+ 2 1 e2k2 (Ti1 t) B22 (Ti1 , Ti )
2k2
+21 2 B1 (Ti1 , Ti )B2 (Ti1 , Ti )B12 (t, Ti1 )

and
 
1 (1 + i K)P (t, Ti )
i
hi = ln + .

i P (t, Ti1 ) 2

Theorem 6.14 (Swaptions in the G2++ model). In the G2++ model, the price
at time 0 of a European payer swaption with swaption maturity T = T on an
IRS depending on the notional value N , the xed rate K, and the set of times
T = {T+1 , . . . , T } is given by numerically computing the one-dimensional integral

PS(0, T, T , N, K)


1 )2
(x 


e 2
12

i (x)
= N P (0, T ) (h1 (x)) i (x)e (h2 (x)) dx,

1 2 i=+1

where

x
(x
1 ) 
h1 (x) =  2  , h2 (x) = h1 (x) + B2 (T, Ti )
2 1 2 ,

2 1 2 1 1 2



i (x) = ci A(T, Ti )exB1 (T,Ti ) , i exB2 (T,Ti ) = 1,
i=+1

ci = Ki for < i < and c = 1 + K ,

 
22 (1 2 ) x 1
i (x) = B2 (T, Ti ) 2 B2 (T, Ti ) +
2 ,
2
1
 
2 1 2 12 1 2
1 = 12 (1 e2k1 T ) +
B12 (0, T ) + B1 (0, T ),
2k1 k2 k1 k2
 
2 1 2 22 1 2
2 = 22 (1 e2k2 T ) +
B12 (0, T ) + B2 (0, T ),
2k2 k1 k2 k1
 
1 e2k1 T 1 e2k2 T 1 2

1 = 1 , 2 = 2 , = B12 (0, T ),
2k1 2k2 1
2
  Ti 
1 2
A(T, Ti ) = exp V (T, Ti ) (u)du .
2 T
38 6. TWO-FACTOR SHORT-RATE MODELS

6.2. HullWhite Two-Factor Model

Definition 6.15 (Short-rate dynamics in the HullWhite two-factor model). In

the HullWhite two-factor model, the short rate is assumed to satisfy the stochastic
dierential equation

dr(t) = k1 ((t) + y(t) r(t))dt + 1 (t),

1 dW

where

dy(t) = k2 y(t)dt + 2 (t),

2 dW y(0) = 0,

k1 , k2 ,
1 , 1 and W
2 > 0 and W 2 are Brownian motions under the risk-neutral

measure such that

dW 2 (t) = dt
1 (t)dW with [1, 1].

Theorem 6.16 (Short rate in the HullWhite two-factor model). Let k1 = k2 .

Let 0 s t T . The short rate in the HullWhite two-factor model is given by
 t  t
r(t) = r(s)ek1 (ts) + k1 (u)ek1 (tu) du +
1 ek1 (tu) dW
1 (u)
s s
 t k2 (tu) k1 (tu)
e e 2 (u) + k1 y(s) ek2 (ts) ek1 (ts)
+k1
2 dW .
s k1 k2 k1 k2

In particular, we have
 t  t
k1
2
r(t) = r(0)ek1 t + k1 (u)ek1 (tu) du + ek2 (tu) dW
2 (u)
0 k1 k2 0
 t 
+ ek1 (tu) 1 (u) k1
1 dW
2 2 (u) .
dW
0 k1 k2

Theorem 6.17 (The HullWhite two-factor model and the G2++ model). Sup-
pose r is the short rate in the HullWhite two-factor model. Assume k1 > k2 and
dene
 t
(t) = r(0)ek1 t + k1 (u)ek1 (tu) du,
0

k1
2
1 2
2 = , 1 = 12
1 2 + 22 ,
2 = ,
k1 k2 1
1 2 W
1 W
2
W1 = , 2.
W2 = W
1

Then r is equal to the short rate in the corresponding G2++ model.

 6.3. CIR2 MODEL 39

Remark 6.18 (The HullWhite two-factor model and the G2++ model). If we
assume k1 < k2 in Theorem 6.17, then we can obtain a similar result. Moreover, it
is also possible to recover the short rate in the HullWhite two-factor model from
the short rate of the G2++ model.

6.3. CIR2 Model

Definition 6.19 (Short-rate dynamics in the CIR2 model). In the CIR2 model,
the short rate is given by
r(t) = x1 (t) + x2 (t),

where x1 and x2 are assumed to satisfy the stochastic dierential equations


dx1 (t) = k1 (1 x1 (t))dt + 1 x1 (t)dW1 (t)

and

dx2 (t) = k2 (2 x2 (t))dt + 2 x2 (t)dW2 (t),

where k1 , k2 , 1 , 2 , 1 , 2 > 0 such that 2k1 1 > 12 and 2k2 2 > 22 and W1 and
W2 are independent Brownian motions under the risk-neutral measure.

Theorem 6.20 (Zero-coupon bond in the CIR2 model). In the CIR2 model, the
price of a zero-coupon bond with maturity T at time t [0, T ] is given by

P (t, T ) = A1 (t, T )A2 (t, T )ex1 (t)B1 (t,T )x2 (t)B2 (t,T ) ,

where Ai and Bi for i {1, 2} are as in Theorem 4.20 with k, , and replaced by
ki , 1 , and i , respectively.

Theorem 6.21 (Bond-price dynamics in the CIR2 model). In the CIR2 model,
the price of a zero-coupon bond with maturity T satises the stochastic dierential
equations

dP (t, T ) = r(t)P (t, T )dt 1 x1 (t)B1 (t, T )P (t, T )dW1 (t)

2 x2 (t)B2 (t, T )P (t, T )dW2 (t)

and
1 (12 B12 (t, T ) 1)x1 (t) + (22 B22 (t, T ) 1)x2 (t)
d = dt
P (t, T ) P (t, T )
 
1 x1 (t)B1 (t, T ) 2 x2 (t)B2 (t, T )
+ dW1 (t) + dW2 (t).
P (t, T ) P (t, T )
40 6. TWO-FACTOR SHORT-RATE MODELS

Theorem 6.22 (T -forward measure dynamics of the short rate in the CIR2
model). Under the T -forward measure QT , the short rate r in the CIR2 model
satises r(t) = x1 (t) + x2 (t) such that x1 and x2 are solutions of the stochastic
dierential equations
  
dx1 (t) = k1 1 (k1 + 12 B1 (t, T ))x1 (t) dt + 1 x1 (t)dW1T (t)

and
  
dx2 (t) = k2 2 (k2 + 22 B2 (t, T ))x2 (t) dt + 2 x2 (t)dW2T (t),

where the QT -Brownian motions W1T and W2T are dened by


dW1T (t) = dW1 (t) + 1 x1 (t)B1 (t, T )

and

dW2T (t) = dW2 (t) + 2 x2 (t)B2 (t, T ).

Theorem 6.23 (Forward-rate dynamics in the CIR2 model). In the CIR2 model,
the instantaneous forward interest rate with maturity T is given by

f (t, T ) = k1 1 B1 (t, T ) + k2 2 B2 (t, T ) + x1 (t) B1 (t, T ) + x2 (t) B2 (t, T )
T T
and satises the stochastic dierential equation
 
df (t, T ) = 1 x1 (t) B1 (t, T )dW1T (t) + 2 x2 (t) B2 (t, T )dW2T (t).
T T

6.4. LongstaSchwartz Model

Definition 6.24 (Short-rate dynamics in the LongstaSchwartz model). In

the LongstaSchwartz model, the short rate is given by

r(t) = 12 x
1 (t) + 22 x
2 (t),

where x
1 and x
2 are assumed to satisfy the stochastic dierential equations

x1 (t) = k1 (1 x
d 1 (t))dt + x
1 (t)dW1 (t)

and

x2 (t) = k2 (2 x
d 2 (t))dt + x
2 (t)dW2 (t),

where k1 , k2 , 1 , 2 , 1 , 2 > 0 such that 2k1 1 > 1 and 2k2 2 > 1 and W1 and W2
are independent Brownian motions under the risk-neutral measure.
 6.5. CIR2++ MODEL 41

Theorem 6.25 (The LongstaSchwartz model and the CIR2 model). Suppose
r is the short rate in the LongstaSchwartz model. Dene

1 = 12 1 and 2 = 22 2 .

Then r is equal to the short rate in the corresponding CIR2 model.

6.5. CIR2++ Model

Definition 6.26 (Short-rate dynamics in the CIR2++ model). In the CIR2++

model, the short rate is given by

r(t) = x1 (t) + x2 (t) + (t),

where is deterministic and x1 and x2 are assumed to satisfy the stochastic dier-
ential equations

dx1 (t) = k1 (1 x1 (t))dt + 1 x1 (t)dW1 (t)

and

dx2 (t) = k2 (2 x2 (t))dt + 2 x2 (t)dW2 (t),

where k1 , k2 , 1 , 2 , 1 , 2 > 0 such that 2k1 1 > 12 and 2k2 2 > 22 and W1 and
W2 are independent Brownian motions under the risk-neutral measure.

Theorem 6.27 (Zero-coupon bond in the CIR2++ model). In the CIR2++

model, the price of a zero-coupon bond with maturity T at time t [0, T ] is given
by
  
T
P (t, T ) = exp (u)du P CIR2 (t, T ),
t

where P CIR2 is P from Theorem 6.20.

Theorem 6.28 (Forward rate in the CIR2++ model). In the CIR2++ model,
the instantaneous forward rate with maturity T is given by

f (t, T ) = (T ) + f CIR2 (t, T ),

where f CIR2 is f from Theorem 6.23.

42 6. TWO-FACTOR SHORT-RATE MODELS

Theorem 6.29 (Calibration in the CIR2++ model). If the CIR2++ model is

calibrated to a given interest rate structure {f M (0, t) : t 0}, then

(t) = f M (0, t) f CIR2 (0, t),

where f CIR2 is f from Theorem 6.23.