Abstract The technique of singular perturbation can be applied to xed income derivative pricing.

It provides a convenient and ecient way to account for stochastic interest rate volatility. We evaluate the yield curve tting performance of a perturbation corrected Vasicek model by comparing it to the Fong-Vasicek model. It is found that the accuracies of the perturbation scheme and the exact analytic scheme are comparable, while the former requires much less computational time. We extend this scheme to a perturbation corrected CIR model, in which case the advantage in speed is diminished due to the need for numerical methods..

A Study on Singular Perturbation Correction to Bond Prices Under Ane Term Structure Models
Frank Fung A REPORT SUBMITTED IN FULFILLMENT OF THE REQUIREMENT FOR THE INDEPENDENT STUDY OF THE BERKELEY MFE PROGRAM 15 October 2010

Contents
1 Introduction 2 Literature Review 2.1 Mathematical Background . . . . . . . . . . . . . . . . . . 2.2 Application of Singular Perturbation in Derivative Pricing 2.2.1 Equity Derivatives . . . . . . . . . . . . . . . . . . 2.2.2 Fixed Income Derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 4 4 6 6 7

3 Results and Discussion 10 3.1 Performance of Singular Perturbation Under Fong-Vasicek Model 10 3.1.1 Application of Singular Perturbation Under Fong-Vasicek Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 3.1.2 Comparison to Analytic Bond Prices . . . . . . . . . . . . 15 3.2 Singular Perturbation Under CIR Model . . . . . . . . . . . . . . 18 4 Conclusion 22

Chapter 1

Introduction
Ane term structure models are a family of models that share the same underlying mathematical structure [13, 12]. One of the advantages of ane models is their mathematical tractability, namely the zero-coupon bond price can be expressed as an exponential of some ane functions of the underlying processes. This feature of ane models greatly facilitates their calibration to the yield curve. Well known single factor ane term structure models include short rate models such as Ho-Lee, Vasicek and CIR models. On the other hand, multifactor ane term structure models allow for more exibility and diversity. One way to utilize the additional degrees of freedom is to make the short rate a sum of more than one processes, as in the case of Longsta and Schwartz [10]. Due to the mixing of the two processes, randomness is introduced into the interest rate volatility implicitly. Alternatively, one can explicitly designate a stochastic process to represent the dynamics of the short rate variance, as in the case of Fong-Vasicek model [14]. However, as we will see shortly, the computational cost of introducing stochastic volatility in such a way is quite high. On the other hand, empirical evidence shows that interest rates and interest rate volatility vary on dierent timescales [9], which is a fact we can exploit, together with the singular perturbation technique, to correct the zero-coupon bond prices for stochastic volatility. The perturbation correction terms are in dierent orders of the reciprocal of variance mean-reversion rate, hence if the interest rate volatility is fast mean-reverting the rst order correction term would be able to capture most of the eect of stochastic volatility. In this report we investigate how the theoretical recipe proposed in [1] behaves in practice. We are mainly interested in the relative gain in accuracy of such a perturbation correction scheme compared to its uncorrected single-factor counterpart, and the relative saving in computational eorts of it compared to a full treatment of stochastic volatility. We choose to conduct our study with the Vasicek and CIR models because, rst of all, their simplicity allows us to focus on the analysis of interest, and secondly the uncorrected single-factor versions of them are well known. Nevertheless, we note that the application of the correction scheme is not limited to the two cases presented here, and the extension 2

to other models would require further investigation. This report is organized as follows. Chapter 2 is a literature review. In Section 2.2, we briey review the mathematical background of singular perturbation problems and discuss how it diers from regular perturbation problems. Section 2.2.1 and 2.2.2 are reviews on the application of singular perturbation techniques in equity derivatives and xed income instruments, respectively. In Chapter 3, we derive the formula for perturbation correction specically for the Fong-Vasicek model in Section 3.1.1, which is followed by a yield curve tting comparison to the analytic results in Section 3.1.2. Section 3.2 presents the perturbation correction to bond prices under a CIR model and an overall comparison. We summarize our investigation in Chapter 4.

Chapter 2

Literature Review
2.1 Mathematical Background

Here we provide a brief review on the topic of perturbation. Readers are referred to [4, 5, 6, 7] for a more detailed treatment. Perturbation theory is the method of nding mathematical solutions by treating the full problem as a perturbed simpler problem. The method has a long history of applications in various elds, including but not limited to uid dynamics, celestial mechanics as well as quantum mechanics. Consider a trivial example. Suppose we have to solve x2 1 = x The two quadratic roots are r 2 1+ (2.2) 2 4 Depending on the desired accuracy, we can now perform a Taylor expansion to Equation (2.2) to obtain an approximated solution. The leading terms in the Taylor expansion are 2 (2.3) + O 3 2 8 where O () is the large O notation. As 0, Equation (2.1) becomes simply x2 1 = 0 with solutions x 1, and the series solution given by Equation (2.3) converges uniformly to these solutions for all x. When this is the case, the perturbation problem is said to be regular. Alternatively, consider an ODE x = 1 + dy + y = cos x dx (2.4) (2.1)

with initial condition y (0) = 0. Naively one may be tempted to substitute a formal expansion of the form y (x) = which would produce a series solution
P

n yn (x)

(2.5)

n=0

y (x) = cos x + sin x 2 cos x +

(2.6)

The problem with this candidate is that the initial condition y (0) is not satised, and hence the approach that we used in the case of regular perturbation above fails. In fact the solution to the nonhomogeneous ODE in Equation (2.4) is Z 1 x/ x t/ y (x) = e e cos tdt (2.7) 0

Note that unlike the naive attempt before, this solution actually satises the initial condition y (0) = 0. The question is then whether we are able to create out of Equation (2.8) a series solution in powers of . Note that ex/ is a quickly varying function in the vicinity of x = 0. It can be shown that the series Sm (x) =
X

as can be obtained by the method of variation of parameters or undetermined coecients. Partial integration to Equation (2.7) gives Z x y (x) = cos x ex/ + ex/ et/ sin tdt (2.8)
0

n=0

i h (1)n n cosn (x) ex/ sinn (x)

(2.9)

since

is a legitimate approximation satisfying the initial condition. The convergence of this series to the exact solution as 0, however, is nonuniform in the sense that lim lim Sm (x) 6= lim lim Sm (x) (2.10)
x0 0 0 x0

Thus we are faced with a singular, as opposed to regular, perturbation problem. This is observed when the small parameter ( in this case) is multiplied by the highest-order derivative in the ODE.

lim lim Sm (x) = 1 x0 0 = 0 lim lim Sm (x)

0 x0

(2.11)

2.2
2.2.1

Application of Singular Perturbation in Derivative Pricing

Equity Derivatives

In Section 2.1 we see that a singular perturbation problem can arise if we are trying to expand a solution with respect to a small parameter that is multiplied by the highest -order derivative. Now if we look at the Black-Scholes PDE: V 1 2 2 2V V + rS S + rV = 0 2 2 S S t (2.12)

2 the highest-order derivative is S V . Thus the condition for singular perturbation 2 is met if , the volatility, plays the role of the small parameter in Section 2.1. Typical value of 2 ranges from 0.01 to 0.2, which is indeed small compared to the option price V . As demonstrated in [8], this fact can be exploited to eciently price European, American and barrier options. Another possible application of singular perturbation in the variable 2 is studied by Fouque et al. [3]. They considered option pricing under the processes

dSt dYt

= rSt dt + f (Yt ) St dWt1 " # 1 v 2 v 2 = (m Yt ) (Yt ) dt + dWt2

(2.13)

in the risk-neutral measure, where (Yt ) is the combined market price of risk (of both the stock price and the volatility), f is some non-negative function and is a small parameter, i.e. the volatility is fast mean-reverting (empirical evidence for and analysis about the mean-reversion of volatility can be found in [2, 9]). Express the option price P as a series P = P0 + and dene the dierential operators L = where 2 + (m y) 2 y y 2 = 2vf (y) 2v (y) xy y 2 1 1 2 2 = + r f (y) + f (y) r t 2 x2 2 x = v2 6 1 1 L0 + L1 + L2 (2.15) P1 + P2 + (2.14)

L0 L1 L2

(2.16)

It can then be shown, by considering L P = 0 and matching terms with the same order in , that 3 2 P1 = (T t) V3 3 + (V2 3V3 ) 2 + (2V3 V2 ) P0 x x x

(2.17)

where V2 and V3 are group parameters that are averaged over the probability distribution of y and P0 is the Black-Scholes price with eective variance 2 = 2 f . In other words, the rst order correction can be obtained by solving an ODE that involves the zeroth order price.

2.2.2

Fixed Income Derivatives

In this section we discuss the procedure for applying singular perturbation to xed income derivative pricing. Once again this is motivated by the fact that interest rate volatility varies on a dierent (shorter) timescale from the interest rate itself. Since the detailed derivation for the specic case of Fong-Vasicek would be provided in Section 3.1.1, we only outline the method here. Consider the processes drt dYt = a(r rt )dt + f (Yt )dWt1 = (m Yt )dt + dWt2 (2.18)

where both the interest rate and the interest rate volatility are mean-reverting, and f is some non-negative function. Expanding the bond price as a series and dening a set of dierential operators properly as we did in Section 2.2.1, it can be shown that the lowest order correction term satises LLHS P1 = LRHS (V1 , V2 , V3 ) P0 (2.19)

for some dierential operators LLHS and LRHS . Although the procedure here is formally identical to what we have seen in Section 2.2.1, there are two subtle dierences. First, in Section 2.2.1, Equation (2.17) suggests that we can calculate the option price correction after we have estimated V2 and V3 from the historical stock price time series. On the other hand for xed income derivatives pricing, since we have an observable yield curve, we can calibrate our model using the stochastic volatility corrected bond prices of zero-coupon bonds. That is, the group parameters V1 , V2 and V3 can be backed out from the yield curve. This is particularly practical if we are dealing with ane models, in which case the bond price correction term P1 could have closed-form solution, as we shall see later. Secondly, the method introduced here is exible enough to be applied to dierent ane short rate models. With these two observations we move on to the next chapter, where we compare the application of singular perturbation to yield curve tting under dierent models (Vasicek and CIR) and during dierent periods. We will also compare how the 7

approximation performs alongside an exact treatment of stochastic volatility under Fong-Vasicek. Figure 2.1 and 2.2 are attempts to reproduce the results obtained in [1]. The Vasicek model is considered and both the uncorrected and perturbation corrected curves are shown. In Figure 2.1 the uncorrected and perturbation corrected yield curves have sum of squared errors of 4.5409 105 and 1.2793 105 , respectively. In Figure 2.2 the uncorrected and perturbation corrected yield curves have sum of squared errors of 9.4260 106 and 6.2520 107 , respectively.
0.06 0.059 0.058 0.057 0.056 0.055 0.054 0.053 0

Yield

10

15 20 Maturity (year)

25

30

Figure 2.1: Fitted yield curves to swap rates observed on 09/07/1998. The crosses are the raw data points, the red curve is tted with Vasicek bond prices and the blue curve is tted with perturbation corrected Vasicek bond prices.

0.062

0.061

0.06
Yield

0.059

0.058

0.057

0.056 0

10

15 20 Maturity (year)

25

30

Figure 2.2: Fitted yield curves to swap rates observed on 08/07/1998. The crosses are the raw data points, the red curve is tted with Vasicek bond prices and the blue curve is tted with perturbation corrected Vasicek bond prices.

Chapter 3

Results and Discussion

3.1
3.1.1

Performance of Singular Perturbation Under Fong-Vasicek Model

Application of Singular Perturbation Under FongVasicek Model

In Section 2.2.2 we see how singular perturbation method produces a rst order correction to the zero-coupon bond price in the presence of stochastic volatility. One question that is of interest is the performance of this scheme in capturing the eect of volatility. Ideally, we would want to study a model having the same form as Equation (2.18), with a specied functional form for f and with analytic zero-coupon bond price. Unfortunately, we are not aware of such a model. Alternatively, we try to shed light on the comparison by investigate the Fong-Vasicek model. We derive in details the bond price obtained by singular perturbation correction and compare it to the analytic solution [11], which requires numerical integration. The derivation presented here follows [1] closely, with the missing steps lled in. The dynamics of the short rate and the interest rate volatility, respectively, follow the system of equations: drt dYt p Yt dWt1 p = ( Yt )dt + Y Yt dWt2 = a(r rt )dt + (3.1)

where hdWt1 dWt2 i = dt. Comparing to the system of stochastic dierential equations in [1], which we reproduce here, drt dYt = a(r rt )dt + f (Yt )dWt1 = (m Yt )dt + dWt2 10 (3.2)

we see that the diusion of Yt here is a constant, while the Fong-Vasicek variance follows a CIR process. Inspired by [15], we seek a transformation z such that z(Y ) = Z
Y

(3.3)

and we succeeded in making the diusion coecient constant. Recall that the order matching scheme described in Section 2.2.1 requires the rate of mean reversion of interest rate volatility to be high, which in turn dictates the drift coecient in the volatility process (i.e. in Equation (2.18)) be large. On the other hand, in Equation (3.4) we can no longer be sure about the rate of mean reversion due to the dependence of the drift coecient on z. Hence we have to go back to the original Fong-Vasicek SDEs as a starting point. Returning to Equation (3.1), the dierential equations in risk-neutral measure becomes drt dYt h p i p a(r rt ) (Yt ) Yt dt + Yt dWt1 h i p p = ( Yt ) Y Yt (Yt ) dt + Y Yt dWt2 = (3.5)

It can be easily shown that the appropriate transformation is z(Y ) = Y 1/2 (up to a factor). Using Itos lemma, the dynamics of z is 1 2 1 1 1 2 dz = (3.4) Y z dt + Y dWt2 2z 8 z 2

where and are the two market prices of risk and + corresponding Feynman-Kac PDE is

p 1 2 . The (3.6)

1 2 t P + yx P + [a(r x) (y) y] x P xP 2 1 2 2 +Y yxy P + 2 yy P + [( y) Y y(y)] y P = 0 Y 2 To save space we write it as L P = 0

(3.7)

where the subscript is a reminder that the dierential operator L depends on . We then rearrange the dierential operators into three groups, 1 2 2 y + ( y)y 2 Y y 2 = Y yxy Y y(y)y 1 2 = t + yx + [a(r x) (y) y] x x 2 = 11

L0 L1 L2

(3.8)

With 1 r

= Y

= v

the dierential operators, expressed explicitly in powers of , are denes as L0 L1 L2 so that L = 1 1 L0 + L1 + L2 (3.10)
2 = v 2 yy ( y) y 2 = 2vyxy 2v y (y) y 1 2 = t + yx + [a(r x) (y) y] x x 2

(3.9)

Note that L0 contains y dierential operators only and L2 contains no y dierential operator. We seek an asymptotic solution of the form P (t, x, y; T ) = P0 (t, x, y; T ) + The O(1 ) equation is L0 P0 = 0 which indicates that P0 (t, x; T ) is independent of y. The O(1/2 ) equation is L0 P1 + L1 P0 = 0 (3.13) (3.12) P1 (t, x, y; T ) + P2 (t, x, y; T ) + (3.11)

Since P0 = P0 (t, x; T ), L1 P0 = 0 and we conclude that P1 (t, x; T ) is also independent of y. The O(1) equation is L2 P0 + L1 P1 + L0 P2 = L2 P0 + L0 P2 = 0 (3.14)

Noting that L2 contains no y derivative and P0 does not depend on y, by xing a particular x = x0 the term L2 P0 |x=x0 can be thought of as a function of y which we denote as h(y). Then, holding x constant, (L0 P2 + h(y)) |x=x0 = 0 (3.15)

is a Poisson equation for P2 in the variable y and it can be shown that a solution P2 (t, x, y; T )|x=x0 exists only if the so called centering condition is fullled for y [2]. The centering condition is expressed as hhi = hL2 P0 i = 0, where the average 12

is taken with respect to the probability distribution of Yt over the whole range (, ). But we have already shown that P0 (t, x; T ) is independent of y, hence the centering condition simplies to hL2 i P0 = 0. The operator L2 is formally the same as the dierential operator of the Feynman-Kac PDE if we are considering a Vasicek model with constant volatility: 1 2 (3.16) hyi x + [a(r x) h(y) yi] x x 2 1 2 t + 2 x + [a(r x)] x x 2 where 2 hyi and r = r (y) y /a. Therefore the solution to hL2 i P0 = 0 is hL2 i = t + P0 (t, x; T ) = A(T t)eB(T t)x where A(T t) and B(T t) are given by B( ) = 1 ea( ) a (3.18) 2 1 ea( ) 4a3 2 (3.17)

A( ) = exp R RB( ) +

where = T t and R r 2 /2a2 , which is consistent with the yindependence requirement. Note that Equation (3.17) is nothing but the zerocoupon bond price for the one-factor Vasicek model with eective volatility 2 . With the centering condition, we can write L2 P0 = L2 P0 hL2 i P0 = (L2 hL2 i) P0 Substituting back into the Poisson Equation (3.15) would give L0 P2 = (L2 hL2 i) P0 Or equivalently P2 = L1 (L2 hL2 i) P0 + k (x, t) 0 (3.21) (3.20) (3.19)

where the function arises as an integration constant (in the variable y). k Finally, the O ( ) equation is L2 P1 + L1 P2 + L0 P3 = 0 (3.22)

This is a Poisson equation of P3 , and a solution exists only if the centering condition hL2 P1 + L1 P2 i = 0 is fullled. Once again, P1 is y-independent and hence hL2 P1 i = hL2 i P1 . Equation (3.22), together with the centering condition, gives

13

hL2 i P1

The second line makes use of the fact that k(x, t) does not depend on y. As P0 is already found, solving Equation (3.23) would give us an expression for P1 . The operator L2 hL2 i is 2 1 y 2 x ( y hi ) x 2 Since L0 contains y dierential operators only, L1 (L2 hL2 i) = 0 2 1 1 L0 y 2 x L1 ( y hi ) x 0 2 (3.24)

= hL1 P2 i = L1 L1 (L2 hL2 i) P0 + L1 k (x, t) 0 = L1 L1 (L2 hL2 i) P0 0

(3.23)

(3.25)

Introduce two functions, and , with the following properties: L0 = y 2 L0 = y hi Equation (3.23) then becomes

(3.26)

hL2 i P1

1 2 L1 (3.27) P0 x x 2 1 2 2 = 2vyxy 2v y (y) y P0 x x 2 0 n x 0 n n hy (x )i = x

n hy (x )i =

Using the relations (3.28)

for some y-independent function (x), and dening

V1 V2 V3

we can rewrite Equation (3.27) as

1 v y0 2 1 = v y0 2v y 0 2 = 2v y 0 x = 14

(3.29)

Due to the centering condition, all y-dependences are contained within the group parameters V1,2,3 , which allows us to solve a PDE in x and t only. Substitute P0 = A( )eB( )x into Equation (3.30) and after some algebra we nd that P1 = 1 2 2 x P1 + [a(r x)] x P1 xP1 + V1 B 3 V2 B 2 + V3 B P0 (3.31) 2

1 2 3 2 t + 2 x + [a(r x)] x x P1 = V1 x + V2 x + V3 x P0 2

(3.30)

with the initial condition P1 (t = T, x) = 0. It is trivial to check that the solution to the PDE is P1 (t, x) = D ( ) A( )eB( )x where 1 1 V3 B ( ) aB ( )2 a2 B ( )3 a3 2 3 V2 1 V1 2 B ( ) aB ( )2 + ( B ( )) a 2 a The corrected zero-coupon bond price up to O 1/2 is therefore D ( ) = P ' 1 + D ( ) A( )eB( )x (3.32)

(3.33)

(3.34)

In summary we showed that compared to the canonical Vasicek model studied in [1], although the volatility dynamics of Fong-Vasicek model has a diusion term proportional to a function of Yt , the rst order correction to the bond price (i.e. Equation (3.34)) remains the same form except that V1,2,3 are dened differently.

3.1.2

Comparison to Analytic Bond Prices

We compare the performance of singular perturbation on Fong-Vasicek to an analytic bond price [11]. The zero-coupon bond price under Fong-Vasicek model is P ( , r) = A ( ) eB( )rC( )y , with A ( ), B ( ) and C ( ) give by the system of ordinary dierential equations dA d dB d dC d = A (ar B + C) = aB + 1 = B C Y C 15 B2 2 C 2 Y Y BC 2 2

(3.35)

Figure 3.1: Comparison of the two yield curve tting schemes. with initial conditions A (0) = 1, B (0) = 0 and C (0) = 0. The solutions to the A and B equations are 1 ea a

B ( ) =

(3.36) Z

A ( ) = exp r + r B ( )

C (s) ds

Before going into yield curve tting results, we shall inspect the connection between the Fong-Vasicek analytic bond price and perturbation correction term. If the approximation scheme is correct, we should have Z exp (r + r B ( ) B ( ) r) exp C (s) ds exp (C ( ) y) (3.37) 0 2 2 = 1 + D ( ) exp R RB( ) + 3 1 ea( ) + B ( ) r + O () 4a

As a reminder, = 1/. The reason singular perturbation is required is now apparent. Although the correction to the bond price is small under our assumptions, it cannot be easily obtained by performing a series expansion directly on the Fong-Vasicek analytic price since the parameter appearing in the exponential, , is not small. To t the yield curve with the analytic Fong-Vasicek bond price, we approximate C ( ) using Euler method starting with the initial condition C (0) = 0. R The integral C (s) ds within A ( ) is approximated using a Riemann sum. The singular perturbation results are identical to those from Section 2.2.2 because, as we have shown in the previous section, the perturbation term is not altered by a change in the variance SDE diusion coecient (it is absorbed in the group parameters). Figure 3.1 shows the details of the two schemes using nonlinear least square tting in Matlab. Figure 3.2 shows the tted yield curves. Judging from Figure 3.2 and also from the tting errors reported in Figure 3.1, we see that the singular perturbation scheme performs better in terms of 16

0.06 0.059 0.058 0.057 0.056 0.055 0.054 0.053 0

Yield

10

15 20 Maturity (years)

25

30

Figure 3.2: Fitted yield curves to swap rates observed on 09/07/1998. The crosses are the raw data points, the red curve is tted with analytic FongVasicek bond prices and the blue curve is tted with perturbation corrected Vasicek bond prices. computational speed but does not do as well in terms of tness to data. This is to be expected since the perturbation scheme is accurate only up to O ( ). Another observation is that the optimized parameters for the analytic Fong-Vasicek scheme are the variables that enter into the SDE of Equation (3.1), while there is no intuitive interpretation for the optimized parameters of the perturbation scheme. We would like to point out two issues in the implementation of the yield curve tting schemes. First, the longer CPU time in the analytic scheme is to a large extent due to looping when implementing the Euler scheme and the numerical integration for C ( ). The relative disadvantage in speed of the analytic scheme may be reduced under a dierent implementation. Second, the analytic bond price depends on y, which is an unobservable quantity. We proxy y with the historical variance of the one-week yield for the analytic scheme. Figure 3.3 shows a yield curve that is less demanding for the Vasicek model, in which case the Fong-Vasicek and the perturbation prices are very close (sum of squared error of 5.2853 107 for the former versus 4.5923 107 for the latter).

17

0.062

0.061

0.06
Yield

0.059

0.058

0.057

0.056 0

10

15 20 Maturity (year)

25

30

Figure 3.3: Fitted yield curves to swap rates observed on 08/07/1998. The crosses are the raw data points, the red curve is tted with analytic FongVasicek bond prices and the blue curve is tted with perturbation corrected Vasicek bond prices. The two curves are indistinguishable under this resolution.

3.2

Singular Perturbation Under CIR Model

Here we extend the singular perturbation correction to the CIR model. We rst briey review the partial results presented in [1]. The dynamics of the two-factor CIR model we study is described by the processes drt dYt = a (r rt ) dt + f (Yt ) rt dWt1 = rt (m Yt ) dt + rt dWt1 + 0 dWt2 (3.38)

where dWt1 and dWt2 are Wiener processes under the risk-neutral measure. The dierential operators in this case are L0 L1 L2 2 = x v 2 y + (m y) y 2 = 2vxf (y) xy 1 2 = t + f (y)2 xx + a(r x)x x 2 (3.39)

Note that unlike when we studied the Vasicek model in Section 3.1.1 where a change of measure is performed, here we start working in the risk-neutral measure directly. Expressing the zero-coupon bond price as 18

P (t, x, y) = P0 (t, x) + it can be shown that

P1 (t, x) + O ()

(3.40)

P0 (t, x) = A ( ) eB( )x where 2e(+a) /2 A ( ) = ( + a) (e 1) + 2 2 e 1 B ( ) = ( + a) (e 1) + 2 p = a2 + 2 2 2ar /2

(3.41)

(3.42)

The correction term then satises

3 hL2 i P1 = V3 xx P0 P1 (T, x) = 0

(3.43)

which has a solution P1 (t, x) = (D1 ( ) x + D2 ( )) A ( ) eB( )x where D1 and D2 satisfy the ODEs D1 = V3 B 3 2 B + a D1 D2 = ar D1 D1 (0) = D2 (0) = 0 (3.44)

(3.45)

This is a linear rst-order ODE that can be solved by integrating factor. To nd the integrating factor, we set the RHS to be zero and solve Z Z 2 du B ( ) + a d (3.47) = u 19

Unlike in the case of singular perturbation for the Vasicek model where the correction depends on one function D that can be expressed in terms of B ( ), here we are faced with two functions D1 and D2 that are related through a system of coupled nonhomogeneous dierential equations. Rearranging the terms in Equation (3.45), we have (3.46) + 2 B + a D1 = V3 B 3

0.06 0.059 0.058 0.057 0.056 0.055 0.054 0.053 0

Yield

10

15 20 Maturity (year)

25

30

Figure 3.4: Fitted yield curves to swap rates observed on 09/07/1998. The crosses are the raw data points, the green curve is tted with CIR bond prices and the blue curve is tted with perturbation corrected CIR bond prices. The integrating factor u is "
2 (

u ( ) = c exp 2

Interested readers are referred to Appendix A for details. With the integrating factor given by Equation (3.48), the full solution to the nonhomogeneous ODE is R 3 u ( ) V3 B ( ) d + c D1 = (3.49) u ( ) where c can be determined using the initial condition. The initial condition D1 (0) = 0 requires that c = 0. Figure 3.4 shows the tted yield curves of CIR (with a sum of squared error 3.9777 105 ) and perturbation corrected CIR models (with a sum of squared error 3.0147 106 ). Although the perturbation corrected CIR model has only one group parameter (V3 ) available for tting, its performance is comparable to that of the perturbation corrected Vasicek model, which has three group parameter, V1 , V2 and V3 (see Section 3.1.2). Figure 3.5 summarizes all the yield curve tting results performed on the 09/07/1998 data. Our results suggest a number of cautions for yield curve tting in practice. First, a larger number of free parameters to be optimized 20

# + a) 2 log ( + a) e 1 + 2 a 2 a2

(3.48)

Figure 3.5: A summary of all the yield curve tting schemes investigated. All ttings are done on the 09/07/1998 data. Vas is the uncorrected Vasicek model, Vas is the perturbation corrected Vasicek model, F-V is the Fong-Vasicek model, CIR is the uncorrected CIR model and CIR is the perturbation corrected CIR model. does not necessarily guarantee a better performance. The performance is also heavily aected by the model specication and the implementation, especially if numerical methods are required to compute the zero-coupon bond price. Secondly, the optimized parameters in the Fong-Vasicek model are the drift and diusion coecients of the underlying processes, while the optimized parameters in the perturbation schemes (i.e. the group parameters V1 , V2 and V3 in Vas and V3 in CIR ) have no intuitive interpretation. The question of whether it is possible to back out the SDE parameters from the group parameters would call for further study, but assuming it is possible it would certainly require numerical integration. Hence, if we are interested in nding the dynamics implied by the yield curve under a certain model, the singular perturbation scheme is not feasible; on the other hand if the main objective is to price xed income derivatives eciently, the interpretations of the optimized parameters is not so important and the feasibility of the perturbation correction may be justied.

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Chapter 4

Conclusion
We reviewed the mathematical background of singular perturbation technique and the application of it in equity, as well as in xed income, derivatives pricing. Singular perturbation arises from the lack of uniform convergence, which is observed when a small parameter is multiplied by the highest order derivative in a dierential equation. This is exactly the case in the Black-Scholes PDE, given that the variance is small. This fact can be exploited to introduce stochastic volatility corrections. We demonstrated in both equity and xed income derivatives pricing how singular perturbation allows us to expand the full solution as a series with terms of dierent orders in , where is the reciprocal of the variance mean-reversion rate. To evaluate the performance of the perturbation scheme under investigation, we proceeded to t the yield curve using two methods: tting with Fong-Vasicek bond prices, and tting with rst-order perturbation corrected Vasicek bond prices. We presented a detailed derivation that gives us the expression for the correction term P1 . Since the Fong-Vasicek prices are exact in accounting for stochastic interest rate volatility, it serves as an analytic benchmark for the perturbation scheme. The tting test is conducted on an S-shaped and a monotonically increasing yield curves. We found that in the former case, while the perturbation scheme slightly underperforms relative to the analytic scheme in terms of minimizing the sum of squared error, it is about 200 times faster. In the latter case, the dierence in error minimization is minimal. Finally, we studied the application of singular perturbation technique to the CIR model. Unlike the perturbation corrected Vasicek model under which the correction term has a closed form, here the correction can only be calculated using numerical integration. The computational time advantage of the perturbation scheme is greatly reduced, but we also found that the tness of the corrected CIR model is very good despite its smaller number of group parameters. Directions for further investigations include backing out the underlying process coecients from the group parameters, as well as extending the technique to non-ane interest rate models.

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Appendix A: Integrating Factor for D1 Under CIR Model

The full nonhomogeneous ODE is 2 + B + a D1 = V3 B 3

(4.1)

The general solution u should solve Z Z 2 du B ( ) + a d + c = u

(4.2)

With the change of variable

Evaluating the LHS and substituting Equation (3.42) into the RHS, we have Z 2 e 1 d a (4.3) log u = 2 ( + a) (e 1) + 2 d d e 1 = e d Z 2 d a = log u = 2 ( + a) + 2 ( + 1)

(4.4)

it can be shown that the general solution to Equation (4.1), which is also the integrating factor for solving the original nonhomogeneous ODE, is "
2 (

u ( ) = exp 2

which can be readily veried by taking derivative with respect to .

# + a) 2 log ( + a) e 1 + 2 a 2 a2

(4.5)

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