Professional Documents
Culture Documents
. (4)
(??) implies that r
t
is Gaussian at each t, with
expectation:
E
Q
[r
t
] = r
0
e
at
+
a
(1 e
at
), and
variance:
Var
Q
[r
t
] =
2
E
_
__
t
0
e
a(ts)
dw(s)
_
2
_
=
2
_
t
0
e
2a(ts)
ds =
2
2a
(1e
2at
).
3
Dynamics of Bond Price
We now show that the bond price is lognormally distributed in the Vasicek model:
By denition of the risk-neutral measure Q, the zero coupon bond price is:
P
t
(T) = E
Q
_
e
_
T
t
r(s) ds
| F
t
_
. (5)
From (??), (interchanging t, s)
P
t
(T) = A(t, T)e
B(t,T)r
t
(6)
B(t, T) =
_
T
t
e
a(st)
ds, and
A(t, T) = E
_
e
_
T
t
{
a
(1e
a(st)
)+
_
s
t
e
a(s)
dw()
}
ds
_
.
A(t, T), B(t, T) deterministic, r
t
Gaussian P
t
(T) lognormal.
4
Explicit Bond Pricing Formula
Can evaluate A(t, T), B(t, T) - see Lamberton & Lapeyre, pages 128-129.
Alternative approach: use P
t
(T) = V (t, r
t
), where V (t, r) solves BVP consisting of
PDE:
V
t
+ ( ar)V
r
+
1
2
2
V
rr
= rV
subject to the nal-time condition V (T, r) = 1 for all r.
Guess a solution of the form:
V (t, r; T) = A(t, T)e
B(t,T)r
.
5
Considered as functions of t, A(t, T) and B(t, T) solve the ODEs:
A
t
AB +
1
2
2
AB
2
= 0 and B
t
aB + 1 = 0
subject to:
A(T, T) = 1 and B(T, T) = 0.
Get:
B(t, T) =
1
a
(1 e
a(Tt)
)
and:
A(t, T) = exp
__
a
2
2a
2
_
(B(t, T) T + t)
2
4a
B
2
(t, T)
_
.
6
Term Structure and Volatility
Only three parameters special term structure.
By denition, the initial instantaneous forward rate curve f
0
(T) =
ln P
0
(T)
T
.
After some calculations, in the Vasicek model, one has:
f
0
(T) =
a
+ e
aT
_
r
0
a
_
2
2a
2
(1 e
aT
)
2
.
Volatility of f, (t, T) is dened by
df
t
(T) = (stu) dt + (t, T) dw
t
.
ln P
t
(T) = ln A(t, T) B(t, T)r
t
, implies
f
t
(T) =
T
ln A(t, T) +
T
B(t, T)r
t
,
Itos formula gives:
(t, T) =
T
B(t, T) = e
a(Tt)
.
7
Validity of Blacks Formula
We now show that P
t
(T) is lognormal under the forward-risk-neutral measure Q
T
.
(The measure under which tradeables normalized by P(t, T) are martingales.)
Already know that P
t
(T) is lognormal under the risk-neutral measure Q, but here
were interested in a dierent numeraire.
Change-of-numeraire in the one-factor setting:
The risk-neutral measure is associated with the risk-free money-market account
as numeraire (by denition d
t
= r
t
t
dt with
0
= 1).
Say N is another numeraire, and Q is the associated equivalent martingale mea-
sure.
Only positive tradeables can be numeraires, so the risk-neutral process for N is
dN
t
= r
t
N
t
dt +
N
t
N
t
dw
t
where
N
t
is in general stochastic and w is a Q standard Brownian motion.
8
Itos formula gives:
d
_
t
N
t
_
=
t
d(N
1
t
) + N
1
t
d
t
After some algebra:
d
_
t
N
t
_
=
t
N
t
(
N
t
)
2
dt
t
N
t
N
t
dw
t
.
t
N
t
is a Q-martingale, i.e.
d
_
t
N
t
_
=
t
N
t
N
t
dw
t
where w is a Q-Brownian motion.
Therefore:
dw
t
=
N
t
dt + dw
t
.
9
What is the SDE for the short rate in the Vasicek model under the forward-risk-neutral
measure Q
T
?
Numeraire is P
t
(T) = A(t, T)e
B(t,T)r
t
Ito the (uusal lognormal) volatility of P
t
(T) is B(t, T).
The preceding calculation gives:
dw
t
= B(t, T) dt + dw
t
.
Conclusion:
dr
t
= ( ar
t
) dt + dw
t
= [ ar
t
2
B(t, T)] dt + dw
t
,
where w is a Q
T
standard Brownian motion.
This SDE shows that short rates are normal and bond prices are lognormal, as under
the risk-neutral measure Q.
10