Towards short-rate models.

Bonds and interest rates

A zero coupon bond with maturity date T (T -bond) is a contract which guarantees the
holder 1 dollar to be paid on the date T .
We denote by p(t, T ) the price at time t of a bond with maturity date T .
Bonds and interest rates

A zero coupon bond with maturity date T (T -bond) is a contract which guarantees the
holder 1 dollar to be paid on the date T .
We denote by p(t, T ) the price at time t of a bond with maturity date T .

We assume that

there exists a (frictionless) market for T -bonds for every T > 0;

p(t, t) = 1 for all t.
p(t, T ) is differentiable w.r.t. T .
Bonds and interest rates

A zero coupon bond with maturity date T (T -bond) is a contract which guarantees the
holder 1 dollar to be paid on the date T .
We denote by p(t, T ) the price at time t of a bond with maturity date T .

We assume that

there exists a (frictionless) market for T -bonds for every T > 0;

p(t, t) = 1 for all t.
p(t, T ) is differentiable w.r.t. T .

At time t, we can make a contract guaranteeing a riskless rate of interest over the
future interval [S, T ]. Such an interest rate is called a forward rate.
Simple forward rates
The simple forward (LIBOR) rate L is the solution to

p(t, S)
1 + (T − S)L = .
p(t, T )
Simple forward rates
The simple forward (LIBOR) rate L is the solution to

p(t, S)
1 + (T − S)L = .
p(t, T )

Hence
p(t, T ) − p(t, S)
L(t, S, T ) = − .
(T − S)p(t, T )
Simple forward rates
The simple forward (LIBOR) rate L is the solution to

p(t, S)
1 + (T − S)L = .
p(t, T )

Hence
p(t, T ) − p(t, S)
L(t, S, T ) = − .
(T − S)p(t, T )

The continuously compounded forward rate R is the solution to

p(t, R)
e (T −S)R = .
p(t, T )
Simple forward rates
The simple forward (LIBOR) rate L is the solution to

p(t, S)
1 + (T − S)L = .
p(t, T )

Hence
p(t, T ) − p(t, S)
L(t, S, T ) = − .
(T − S)p(t, T )

The continuously compounded forward rate R is the solution to

p(t, R)
e (T −S)R = .
p(t, T )

Hence
log p(t, T ) − log p(t, S)
R(t, S, T ) = − .
T −S
Spot/forward rates

The spot rate is the yield-to-maturity on a zero-coupon bond.

Spot/forward rates

The spot rate is the yield-to-maturity on a zero-coupon bond.

The forward rate is the rate on a financial instrument traded on the forward market.
Spot/forward rates

The spot rate is the yield-to-maturity on a zero-coupon bond.

The forward rate is the rate on a financial instrument traded on the forward market.
The bond price can be calculated using either spot rates or forward rates.

Spot rates: L(S, S, T ), R(S, S, T ).

Spot/forward rates

The spot rate is the yield-to-maturity on a zero-coupon bond.

The forward rate is the rate on a financial instrument traded on the forward market.
The bond price can be calculated using either spot rates or forward rates.

Spot rates: L(S, S, T ), R(S, S, T ).

Instantaneous rates:
The instantaneous forward rate with maturity T , contracted at t,

∂ log p(t, T )
f (t, T ) = −
∂T
.
The instantaneous short rate at time t: r (t) = f (t, t).
Bonds and interest rates

Rt
r (s) ds
The money account: Bt = e 0 .
For t ⩽ s ⩽ T we have
RT
p(t, T ) = p(t, s) · e − −s f (t,u) du

In particular, RT
p(t, T ) = e − t f (t,u) du
.

Assume we have

dr (t) = a(t)dt + b(t)dWt

dp(t, T ) = p(t, T )m(t, T )dt + p(t, T )v (t, T )dWt
df (t, T ) = α(t, T )dt + σ(t, T )dWt
Bonds and interest rates

dr (t) = a(t)dt + b(t)dWt

dp(t, T ) = p(t, T )m(t, T )dt + p(t, T )v (t, T )dWt
df (t, T ) = α(t, T )dt + σ(t, T )dWt

We then have

(
α(t, T ) = vT (t, T )v (t, T ) − mT (t, T )
σ(t, T ) = −vT (t, T )
and (
a(t) = fT (t, t)v (t, T ) + α(t, t)
b(t) = σ(t, t)
and
dp(t, T ) = p(t, T ) r (t) + A(t, T ) + 12 |S(t, T )|2 dt + p(t, T )S(t, T )dWt ,
 
RT RT
where A(t, T ) = − t α(t, s)ds, S(t, T ) = − t σ(t, s)ds.
Bonds and interest rates

Fix a number of dates, i.e., points in time, T0 , . . . , Tn . Here T0 is interpreted as

the emission date of the bond, whereas T1 , . . . , Tn are coupon dates.
At time Ti , i = 1, . . . , n, the owner of the bond receives the deterministic coupon
ci .
At time Tn , the owner receives the face value K .

Then the price of the fixed coupon bond at time t < T1 is given by
n
X
p(t) = K · p(t, Tn ) + ci · p(t, Ti )
i=1

Finally, the return of the i-th coupon is defined as ri :

ci = ri (Ti − Ti−1 )K
Bonds and interest rates
If we replace the coupon rate ri with the spot LIBOR rate L(Ti−1 , Ti ):

ci = (Ti − Ti−1 )L(Ti−1 , Ti )K

If we set Ti − Ti−1 = δ and K = 1, then the i-th coupon at time Ti should be

δ
ci = −1
1 − P(Ti−1 , Ti )
which further discounted to time t < T0 should be

p(t, Ti−1 ) − p(t, Ti )

Summing up all the terms we finally obtain the price of the floating coupon bond at
time t
Xn
p(t) = p(t, Tn ) + [p(t, Ti−1 ) − p(t, Ti )] = p(t, T0 )
i=1

This also means that the entire floating rate bond can be replicated through a
self-financing portfolio. (Exercise for you)
Bonds and interest rates
An interest rate swap is basically a scheme where you exchange a payment stream at a
fixed rate of interest, known as the swap rate, for a payment stream at a floating rate
(typically a LIBOR rate).
Denote the principal by K , and the swap rate by R. By assumption, we have a number
of equally spaced dates T0 , . . . , Tn , and payment occurs at the dates Ti , . . . , Tn (not at
T0 ). If you swap a fixed rate for a floating rate (in this case the LIBOR spot rate), then
at time Ti , you will receive the amount

K δL(Ti−1 , Ti )

and pay the amount

K δR

where δ = Ti − Ti−1 .
Bonds and interest rates

Theorem
The price, for t < T0 , of the swap above is given by
n
X
Π(t) = Kp(t, T0 ) − K di p(t, Ti ),
i=1

where
di = Rδ, i = 1, . . . , n − 1,

dn = 1 + Rδ

If, by convention, we assume that the contract is written at t = 0, and the contract
value is zero at the time made, then
p(0, T0 ) − p(0, Tn )
R=
δ ni=1 p(0, Ti )
P
Bonds and interest rates
In most cases, the yield of an interest rate product is the "internal rate of interest" for
this product. For example, the continuously compounded zero coupon yield y (t, T )
should solve
p(t, T ) = e −y (T −t) · 1

which is given by
log p(t, T )
y (t, T ) = −
T −t
For a fixed t, the function T 7→ y (t, T ) is called the (zero coupon) yield curve.
Bonds and interest rates
The yield to maturity, y (t, T ), of a fixed coupon bond at time t, with market price p,
and payments ci , at time Ti for i = 1, . . . , n is defined as the value of y which solves
the equation
X n
p(t) = ci e −y (Ti −t)
i=1

For the fixed coupon bond above, with price p at t = 0, and yield to maturity y , the
duration, D is defined as Pn
Ti ci e −yTi
D = i=1
p
which can be interpreted as the "weighted average of the coupon dates". With the
notations above we have
dp
= −D · p
dy
Bonds and interest rates
The zero-coupon curve (sometimes also referred to as yield curve) at time t is the
graph of the function

L(t, T ), t ⩽ T ⩽ t + 1 (years)
T 7→
Y (t, T ), T > t + 1 (years)

where the L(t, T ) is the spot LIBOR rate and Y (t, T ) is the annually compounded
spot interest rate.
Such a zero-coupon curve is also called the term structure of interest rates at time t.
Under different economic environments, the shape of zero-coupon curve can be very
different, such as the normal curve, flat curve, inverted curve, steep curve, etc.
Bonds and interest rates
The zero-bond curve at time t is the graph of the function
T 7→ P(t, T ), T >t
which, because of the positivity of interest rates, is a T -decreasing function starting
from P(t, t) = 1. Such a curve is also referred to as term structure of discount factors.

Ferstl, R., & Hayden, J. (2010). Zero-Coupon Yield Curve Estimation with the Package termstrc. Journal of Statistical Software,
Bonds and interest rates
In this section we turn to the problem of how to model an arbitrage-free family of zero
coupon bond price process {p(·, T ) : T ⩾ 0}. To model that, we first assume that the
short rate under the objective probability measure P, satisfies the SDE

dr (t) = µ(t, r (t))dt + σ(t, r (t))d W

c(t)

And the only exogenously given asset is the money account, with price process B
defined by the dynamics
dB(t) = r (t)B(t)dt

We further assume that there exists a market for zero coupon T -bond for every value of
T.
Short rate models
Question: Are bond prices uniquely determined by the P-dynamics of the short rate r ?
Answer: No! The market is incomplete. The short rate, as an "underlying", is not
tradable.
Pricing ideas:

Prices of bonds with different maturities will have to satisfy certain internal
consistency relations in order to avoid arbitrage possibilities on the bond market.
If we take the price of one particular ‘benchmark’ bond as given then the prices of
all other bonds (with maturity prior to the benchmark) will be uniquely determined
in terms of the price of the benchmark bond (and the r -dynamics).
Short rate models
Assumption: We assume that there is a market for T -bonds for every choice of T and
that the market is arbitrage free. We assume furthermore that, for every T , the price of
a T -bond has the form
p(t, T ) = F (t, r (t); T )

where F is a smooth function of three real variables. Sometimes we write FT (t, r )

instead of F (t, r (t); T ). Apply Itô’s formula, then

dFT = F T αT dt + FT σT d W
c

where
FtT + µFrT + 12 σ 2 FrrT σFrT
αT = , σT =
FT FT
Bonds and interest rates
Theorem
Assume that the bond market is free of arbitrage. Then there exists a process λ such
that the relation
αT (t) − r (t)
= λ(t)
σT (t)
holds for all t and for every choice of maturity time T .

Theorem
In an arbitrage-free bond market, FT will satisfy the term structure equation
1
FtT + (µ − λσ)FrT + σ 2 FrrT − rFT = 0,
2
T
F (T , r ) = 1

For a general contingent claim X = Φ(r (T )). The price F (t, r (t)) will then satisfy

1
Ft + (µ − λσ)Fr + σ 2 Frr − rF = 0,
2
T
F (T , r ) = Φ(r )
Short rate models
Bond prices are given by the formula p(t, T ) = F (t, r ; T ) where
h RT i
− t r (s)ds
F (t, r ; T ) = EQ
t,r e

Here the martingale measure Q and the subscripts t, r denote that the expectation shall
be taken given the following dynamics for the short rate

dr (s) = (µ − λ)ds + σdW (s),

r (t) = r

For a general contingent claim, the valuation becomes

h RT i
− t r (s)ds
F (t, r ; T ) = EQ
t,r e · Φ(r (T ))

The term structure, as well as the prices of all other interest rate derivatives, are
completely determined by specifying the r -dynamics under the martingale measure Q.
Short rate models

Vasíček
dr = (b − ar )dt + σdW , (a > 0)

Cox–Ingersoll–Ross (CIR)
√
dr = a(b − r )dt + σ r dW

Black–Derman–Toy
dr = Θ(t)rdt + σ(t)rdW

Ho–Lee
dr = Θ(t)dt + σdW

Hull–White
dr = (Θ(t) − a(t)r )dt + σ(t)dW , a(t) > 0

Hull–White (extended CIR)

√
dr = (Θ(t) − a(t)r )dt + σ(t) r dW , (a(t) > 0)
Short rate models
Pinpointing the r -dynamics under the martingale measure Q is of key importance since
all the derivatives pricing problems in a short rate model framework are dependent on
it. The so-called inverting yield curve approach can be utilised to accomplish this:

A particular model involving one or more parameters is chosen, and the entire
parameter vector is denoted as α.
For every conceivable time of maturity T , the term structure equation for the
T-bonds is solved. The theoretical term structure is thus given as

p(t, T ; α) = EQ [F (T , t; r ; α)]

Price data from the bond market is collected. The empirical term structure is
denoted by {p ∗ (0, T ); T ⩾ 0}.
The parameter vector α is chosen in such a way that the theoretical curve fits the
empirical curve as well as possible. This results in the estimated parameter α∗ .
Short rate models
Insert α∗ into µ and σ. Now we have pinned down exactly which martingale measure
we are working with. Let us denote the result by µ∗ and σ ∗ respectively.

We can now compute an interest rate derivative with final payoff χ = Γ(r (T )).
The price process N(t; T ) is given by G (t, r (t)) which solves

Gt + µ∗ Gr + 1 σ ∗2 Grr − rG = 0

2
G (T , r ) = Γ(r )


It is of great importance that the PDEs involved are easy to solve. And it turns out
that some of the models above are much easier to deal with analytically than the
others, and this leads us to the subject of so-called affine term structures.
Short rate models
If the term structure {p(t, T ); 0 ⩽ t ⩽ T , T > 0} has the form

p(t, T ) = F (t, r (t); T ),

where F has the form

f (t, r ; T ) = e A(t,T )−B(t,T )r

and where A and B are deterministic functions, then the model is said to possess an
affine term structure (ATS). It turns out that the ATS is general enough to include lots
of popular models. If the drift µ(t, r ) and diffusion part σ(t, r ) have the form
(
µ(t, r ) = α(t)r + β(t)
σ(t, r ) = γ(t)r + δ(t)

then the model admits an affine term structure.

Short rate models
Pros of Short Rate Models:

Specifying r as the solution of an SDE enables the use of Markov process theory
within a PDF framework.
Often allows for deriving analytical formulas for bond prices and derivatives.

Cons of Short Rate Models:

Economically unreasonable to assume market governed by a single explanatory

variable.
Difficult to achieve a realistic volatility structure for forward rates without complex
models.
Increased realism in the model complicates the inversion of the yield curve.
Forward rate models
An obvious extending idea would, for example, be to present a prior model for the short
rate as well as for some long rate, and one could of course model one or several
intermediary interest rates. The method proposed by Heath-Jarrow-Morton is at the far
end of this spectrum: they choose the entire forward rate curve as their (infinite
dimensional) state variable.

We assume that, for every fixed T > 0, the forward rate has a stochastic
differential which under the objective measure P is given by

df (t, T ) = α(t, T )dt + σ(t, T )d W

f(t)

Here, f (0, T ) = f ∗ (0, T ), where W

f is a d-dimensional P-Wiener process whereas
the α and σ are adapted processes.
Arbitrage-Free Forward Rate Market

Theorem Assume that the family of forward rates is given as above and that the
induced bond market is arbitrage free. Then there exists a d-dimensional column-vector
process
λ(t) = [λ1 (t), . . . , λd (t)]′

with the property that for all T ⩾ 0 and for all t ⩽ T , we have
Z T
α(t, T ) = σ(t, T ) σ(t, s)ds − σ(t, T )λ(t)
t
Martingale Measure and Volatility Structure

Under the martingale measure Q, the process α and σ must satisfy the following
relation, for every t and every T ⩾ t:
Z T
α(t, T ) = σ(t, T ) σ(t, s) ds
t

Thus we know that when we specify the forward rate dynamics (under Q) we may freely
specify the volatility structure. The drift parameters are then uniquely determined.
Forward rate models
Now we illustrate a simple example. Set σ(t, T ) = σ. Then
Z T
α(t, T ) = σ σds = σ 2 (T − t)
t

Then we have
Z t Z t
∗ 2
f (t, T ) = f (0, T ) + σ (T − s)ds + σdW (s),
0 0

i.e.  
T t
f (t, T ) = f ∗ (0, T ) + σ 2 t − + σW (t)
2 2
Consequently,
σ2t 2
r (t) = f (t, t) = f ∗ (0, t) + + σW (t)
2
so the short rate dynamics is

dr (t) = fr (0, t) + σ 2 t dt + σdW (t)

which is exactly the Ho–Lee model, fitted to the initial term structure.
Forward rate models
Interest rate models that utilize infinitesimal rates such as the instantaneous short rate
and forward rates are theoretically appealing due to their mathematical tractability.
However, they exhibit several practical drawbacks:

Instantaneous rates, such as short and forward rates, are theoretical constructs
that cannot be directly observed or measured in real-world markets.
Calibrating models to market instruments like caps or swaptions becomes a
complex numerical task when using models based on instantaneous rates, often
leading to computational difficulties.
Historically, market practitioners have valued caps, floors, and swaptions by
adapting the Black (1976) model. This approach commonly assumes a
deterministic short rate at a single point in time, yet treats the LIBOR rate as
stochastic. Such dual treatment can lead to inherent inconsistencies within the
model framework.
Forward rate models
Rather than focusing on instantaneous interest rates, our approach involves modeling
observable market rates such as LIBOR in LIBOR market models or forward swap rates
in swap market models.

We base our models on discrete market rates, like LIBOR, which are readily
observable and more practical for modeling purposes compared to instantaneous
rates.
With an appropriate numeraire, these market rates can be modeled to follow a
log-normal distribution, aligning with common financial assumptions.
Consequently, our market models yield pricing formulas for interest rate derivatives
such as caps and floors (in the context of LIBOR models) and swaptions (within
swap market models), adhering to the Black-76 framework and validating market
practices.
These models are constructed to facilitate straightforward calibration against
market data for caps, floors, and swaptions, ensuring practical applicability and
efficiency.
Forward rate models
Consider a fixed set of increasing maturities T0 , T1 , . . . , TN and we define αi , by

αi = Ti − Ti−1 , i = 1, . . . , N

The number αi is known as the tenor, which often is a quarter of a year in practice.
Let pi (t) denote the zero coupon bond price p(t, Ti ) and let Li (t) denote the LIBOR
forward rate contracted at t, for period [Ti−1 , Ti ]. A cap or cap rate R and resettlement
dates T0 , . . . , TN is a contract which at time Ti gives the holder of the cap amount

Xi = αi · max[Li (Ti−1 ) − R, 0]

for each i = 1, . . . , N. The cap is thus a portfolio of the individual caplets X1 , . . . , XN .

Black-76 Formula for Caplets

The Black-76 formula for the caplet Xi = αi · max[Li (Ti−1 ) − R, 0] is given by the
expression

CapletB
i (t) = αi · pi (t) · Li (t) · N(d1 ) − R · N(d2 ) (i = 1, . . . , N)

where    
1 Li (t) 1 2
d1 = √ ln + σi (Ti − t) ,
σ i Ti − t R 2
p
d2 = d1 − σi Ti − t

The constant σi is known as the Black Volatility for caplet number i.

Sometimes denoted by CapletB
i (t; σi ).
Forward rate models
In the market, cap prices are not quoted in monetary terms but instead in terms of
implied Black volatilities. There are two types of implied Black volatilities, the flat
volatilities and the spot volatilities (also known as forward volatilities).
First of all, it is easy to see that

Capleti (t) = Capi (t) − Capi−1 (t), i = 1, . . . , N

Then the implied flat volatilities σ1 , . . . , σN are defined as the solutions of the equations
i
X
Capm
i (t) = CapletB
k (t; σi ), i = 1, . . . , N
k=1

The implied spot volatilities σ̂1 , . . . , σ̂N are defined as solutions of the equations

Capletm B
i (t) = Capleti (t; σ̂i ), i = 1, . . . , N

A sequence of implied volatilities σ1 , . . . , σN (flat or spot) is called a volatility term

structure.
LIBOR Market Model Setup
Set-up:

A set of resettlement dates T0 , . . . , TN .

An arbitrage free market bond with maturities T0 , . . . , TN .
A k-dimensional QN -Wiener process W N .
For each i a deterministic function of time σi (t).
An initial non-negative forward rate term structure L1 (0), . . . , LN (0).
For each i, we define W ′i as the k-dimensional Qi -Wiener process generated by
W N under the Girsanov transformation QN → Qi .

If the LIBOR forward rates have the dynamics

dLi (t) = Li (t)σi (t)dW ′i (t), i = 1, . . . , N

where W ′i is Qi -Wiener as described above, then we say we have a discrete tenor

LIBOR market model with volatilities σ1 , . . . , σN .
Theorem: the existence of a LIBOR model with the given volatility structure.
Consider a given volatility structure σ1 , . . . , σN , where each σi is assumed to be
bounded, a probability measure QN and a standard QN -Wiener process W N . Define
L1 , . . . , LN by
N
!
X αk Lk (t) ∗
dLi (t) = −Li (t) σk (t)σk (t) + αk Lk (t) dt + Li (t)σi (t)dW N (t),
1 + αk Lk (t)
k=i+1

for each i where we use the convention N i

P
N (. . .) = 0. Then the Q -dynamics of Li are
given as above in the LIBOR market model. Thus there exists a LIBOR model with the
given volatility structure.