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CT1 CHP 15 Stochastic Interest Rate Models

1) Interest rates are stochastic in nature and can vary randomly over time. This variation is modeled using statistical theory, with interest rates sometimes being independent or having serial correlation. 2) Stochastic interest rate models introduce the idea that the accumulated value at the mean interest rate is different than the mean accumulated value. The accumulated value is a random variable. 3) Under the lognormal distribution for interest rates, the accumulated value and present value of 1 over time also follow lognormal distributions, allowing for exact analysis of their distribution functions. The parameters of the lognormal distributions can be estimated based on the mean and variance of the interest rates.

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204 views14 pages

CT1 CHP 15 Stochastic Interest Rate Models

1) Interest rates are stochastic in nature and can vary randomly over time. This variation is modeled using statistical theory, with interest rates sometimes being independent or having serial correlation. 2) Stochastic interest rate models introduce the idea that the accumulated value at the mean interest rate is different than the mean accumulated value. The accumulated value is a random variable. 3) Under the lognormal distribution for interest rates, the accumulated value and present value of 1 over time also follow lognormal distributions, allowing for exact analysis of their distribution functions. The parameters of the lognormal distributions can be estimated based on the mean and variance of the interest rates.

Uploaded by

Harshal Bhuravne
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© © All Rights Reserved
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CT1 Chapter 15

Stochastic Interest Rate Models


1

Mayur Ankolekar

15th & 22nd March, 2019


FYBSc, DSActEd
Stochastic nature of interest rates

 Interest rates in the future could move randomly


 This means the rate itself could have a variance
 Unlike what was assumed earlier in the course that interest rates
are static

 Variation in interest rates are allowed for based on statistical


theory e.g. interest rates could be i.i.d.r.v. or have a serial correlation
Introducing the idea implicit in
stochastic interest rate models

A. Accumulated value at mean interest rate

≠
B. Mean accumulated value

1. Identify the random variable in A and B


2. Write the formula for the accumulated value for A and B.
3. Assume interest rates over 10 years would be 5% pa (p =
0.2), 7% pa (p = 0.5), 9% pa (p = 0.3), find A and B.
4. Calculate the variance of A.
An and Sn as r.v.
4

Sn = (1+i1) (1+i2) …. (1+in) Note:


An here is the
An = (1+i1) (1+i2) …. (1+in) equivalent of s due n
+(1+i2) …. (1+in)
Sn is just the
+… accumulation of 1
over the period
+ (1+in-1)(1+in)
+(1+in)
Q 15.3: Find the probability that Sn will take value between 1.02 x 1.04n-1, if
yield of 2% pa, 4% pa and 6% pa are equally likely. (Read the note above!)

Answer:
n . 1/3 . (1/3)n-1
Deriving mean and variance of Sn, the acc value
Parameters of interest rate over the investment term E(it) = j, V(it) = s2
5

If the kth moment of Sn is (Sn)k =

then E(Sn)k = E [ ]
=

so, E(Sn) = = = (1+j)n

where E(it) = j

E(Sn2) =
Deriving mean and variance of Sn, the acc value … contd.
6

E(Sn2) =

As E (it)2 = [E(it)]2 + V(it), and


E(it)] = j,V(it) = s2

we get E(Sn2) = [1 + 2j + j2 + s2 ]n

and
V(Sn) = E(Sn2) - {E(Sn)}2
= [(1+j)2 + s2]n - (1+j)2n
Practise problems to compute E(Sn) and V(Sn) under various distributions of interest rates.
Expectation of An or “s due n”
7

An = (1+i1) (1+i2) …. (1+in) An and An-1 follow a


+(1+i2) …. (1+in) recursive relationship
such that:
+…
+ (1+in-1)(1+in) An = (1 + in) (1 + An-1)
+(1+in)

If E(An ) is denoted by μn,


then μn = (1 + in) (1 + μn-1) … n ≥ 2
= (1 + j) (1 + μn-1)
= (1 + j) + (1 + j) (1 + μn-1)

and expands to (1+j) + (1+j)2 + (1+j)3 + … + (1+j)n


i.e., “s due n”
Variance of An or “s due n”
8

E(A12) = E(1 + i1)2 = 1 + 2E(i1) + E(i12)

Define mn = E(An2), so m1 = 1 + 2E(i1) + E(i12)

As E (it)2 = [E(it)]2 + V(it), and E(it)] = j, V(it) = s2

we get m1 = E(A12) = 1 + 2j + j2 + s2

Also, mn = An2 = (1 + 2in + in2) (1 + An-1 + An-12)

V (An) = E (An2) – [E (An)]2


= mn - μn2
Lognormal distribution of interest rate
9

Log normal distribution


A special case where the exact analysis of the distribution function of
Sn is particularly simple.

The log-normal variable of interest rate i.e. LN (1 + it) can take a


positive value and has the multiplicative property

if X1 ~ LN (μ1 , σ12) and X2 ~ LN (μ2 , σ22)

then
X1 X2 ~ LN (μ1 + μ2 , σ12 + σ 22)
Lognormal distribution of an accumulation of 1
10

As the kth moment of Sn is (Sn)k =

If (1 + it) ~ LN (μ , σ2) ,

(1 + i1) ~ LN (μ1 , σ12), (1 + i2) ~ LN (μ2, σ22) and so on

then Sn = (1 + i1) (1 + i2) … (1 + in) ~ LN (nμ , nσ2) .. using independence


property

Note: parameters μ and σ need to be found from solving simultaneously


E (1 + it) = exp (μ + σ2/2) and V (1 + it) = exp (2μ + σ2). [exp (σ2) – 1]
Lognormal distribution of an accumulation of 1 .. Contd.
11

i.e.,
log (Sn) ~ N (nμ , nσ2)
Sn ~ LN (nμ , nσ2)

alternatively,
P (logSn ≤ log s) = Φ [(log s – nμ)/ σ√n]

and,

(log s – nμ)/ σ√n ~ N (0,1)


Lognormal distribution of the PV of 1
12

Vn = (1 + i1)-1 (1 + i2)-1 …. (1 + in)-1


ln Vn = - ln (1 + i1) – ln (1 + i2) - …. - ln (1 + in)
If (1 + it) ~ LN (μ , σ2) ,
then Vn ~ LN (-nμ , nσ2),

i.e.,
log (Vn) ~ N (-nμ , nσ2)

alternatively,
{log v – (-nμ)}/ σ√n ~ N (0,1)

and,
P (Vn ≤ v) = Φ [(log v – (-nμ))/ σ√n]
Applications of Lognormal distribution for stochastic
interest rates
13

If Y ~ LN (μ , σ2), then
E(Y) = exp(μ+σ2/2)
V(Y) = exp(2μ+σ2). exp(σ2 – 1)

If E(1 + it) and V(1 + it) are given and (1+ it) ~LN (μ , σ2) , then the
parameters μ and σ2 can be estimated.

The following example can be solved (Q2, exam style):


A lump sum of $14,000 will be invested at time 0 for 4 years at a constant annual rate
of interest i.e. (1 + i) has a log-normal distribution with mean 1.05 and variance
0.007. What is the probability that the investment will accumulate to more than
$20,000 in 4 years’ time?

Hint: Estimate μ and σ2; S4 ~ LN (4 μ , 4σ2), and the r.v. = 20000/14000.


Find 1 - P(S4 ≤ 10/7)
CT1, IFoA, Sep 2018, Q6
14
In a particular investment fund, it is the rate of return in the tth year. Let Sn be the
accumulation of ₤1 invested over a period of n years. Assume the mean and standard
deviation of it is 0.08 and 0.07 respectively, and that 1 + it is log-normally distributed.

(i) Determine the distribution of S10 [5 marks]

An investor is considering investing ₤6,000 in the fund for 10 years.

(ii) Determine the amount of the accumulated value after 10 yr such that there is a 97.5%
probability of the investor actually achieving an amount greater than this. [3 marks]

Approach:
(i) Calculate the parameters μ and σ in Sn ~ LN (nμ , nσ2) using E (1 + it) = 1 + E(it) =
exp (μ + σ2/2) and V (1 + it) = V (it) = exp (2μ + σ2). [exp (σ2) – 1]

(ii) Calculate P (6,000 S10 > x) = 0.975, i.e. 1 - P (6,000 S10 ≤ x) = 0.975
 P(ln S10 ≤ ln x/6,000) = 0.025
 Φ [ln x/6,000 – 10μ)/ σ√n] = 0.025
 (ln x/6,000 – 10μ)/ σ√n = - 1.96

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