Advanced Derivatives Pricing

Advanced Derivatives Pricing and Applications
Dr Dale Roberts
Australian National University
Semester 2, 2014
FINM3007/MATH3015/MATH6015
Dale Roberts (c) 2011-2014
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Week 1
Vectors and Matrices

Functions of Bounded Variation
Stieltjes Integration
Gaussian Random Variables
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Vectors and Matrices
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Vectors
A vector (or column) of length n is an n 1 array

x1
x2
x = (x 1 , x 2 , . . . , x n )0 =
... .
xn
The superscript 0 means transpose and converts the row
[x 1 x 2 x n ]
to a column.
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Vector-Vector Product
Let x and y be vectors of length n.
We often write x Rn and y Rn .
The dot product or inner product of x and y is given by
0
x y := x y =
n
X
x i yi = x 1 y1 + x 2 y2 + + x n yn .
The norm of a vector x is given by
kxk :=
x0x =
v
uX
n
t
x i2
i=1
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Matrices
An m n matrix is an array of objects consisting of m rows and n columns
a11 a12 a1n

a22 a2n
a
A = [ai j ] = 21

am1 am2 amn
The element ai j is the entry in the i th row and j th column.
So a column of length n is simply a n 1 matrix and a row of length n is a
1 n matrix.
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Matrices
A n n diagonal matrix is a matrix of the form
d1 0
0
0
0 d2 0
.
..
.
.
D=
.
.
.
. 0 dn1 0
0
0
dn
wherein all entries not on the main diagonal are zero.

Also denoted
D = diag(di )1n = diag(d1 , d2 , . . . , dn )
A special case is the identity matrix
I = diag(1, 1, . . . , 1).
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Matrix-Vector Product
The (matrix-vector) product Ax is defined to be the column of length m
whose entry in the i th row is
(Ax)i =
n
X
ai j x j = ai1 x 1 + ai2 x 2 + + ain x n
(1)
j=1
If A = [1 2 n ] is a single row (i.e., m = 1), then (1) becomes

x1
n
x2 X
Ax = [1 2 . . . n ] .. =
j x j.
.
j=1
xn
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If the i th row of A is denoted by

ai = [ai1 ai2 ain ],
then
(Ax)1
a1 x
(Ax)2 a2 x

Ax =
... = ...
(Ax)m
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am x
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If A = [ai j ] and B = [bi j ] are two matrices of the same size. Then
A = B ai j = bi j ,
i, j
A B = [ai j bi j ]
A = [ai j ]
The following laws of matrix-vector multplication hold:
(A)x = (Ax) = A(x)
(Associative law)
A(x + y) = Ax + Ay (Distributive law)
(A + B)x = Ax + B x (Distributive law)
where A, B are n m matrices; , real numbers; and x, y vectors of
length n.
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Matrix-Matrix Product
Let A be an m n matrix. A j denotes the j th column of A and we write
A = [A1 A2 An ].
(A)i j denotes the element of A at row i and column j . Hence, if A = [ai j ]
then (A)i j = ai j .
Let A = [ai j ] be an m n matrix and B = [bi j ] be a p q matrix with
columns B j . The (matrix-matrix) product AB is defined if and only if n = p
and in this case
AB = [AB1 AB2 ABq ]
is a m q matrix.
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Determinants
The determinant of n n matrix A is denoted by det A = |A|.

When n = 1, det A = |[a]| = a.
When n = 2,
a b
det
= ad bc.
c d
Determinants of matrices of size n > 2 are computed in terms of
determinants of matrices of size n 1.
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Determinants
The minor Mi j of ai j in A = [ai j ] is the determinant of the submatrix of A
obtained by deleting the i th row and j th column.
The cofactor of ai j is Ci j = (1)i+ j Mi j .
For each i, j the following hold:
|A| =
|A| =
n
X
k=1
n
X
aik Cik (Expansion along i th row)

ak j Ck j (Expansion along j th row)
k=1
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Determinants
Example
Expanding along the first row:

1 2 3

5 6
4 6
4 5
2

det A = 4 5 6 = 1
7 9 + 3 7 8 = 0.
8 9
7 8 9
Expanding along the second column:

1 3
4 6
1 3
+ 5

|A| = 2
7 9 8 4 6 = 0.
7 9
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Inverses of Square Matrices

A matrix B is an inverse of A if and only if AB = I and BA = I .
In this case, we write B = A1 .
A is said to be invertible or nonsingular when it has an inverse.
Example
cos( ) sin( )
A=
.
sin( ) cos( )
cos( ) sin( )
=
.
sin( ) cos( )
You can verify that AA1 = I and A1 A = I .
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Nondecreasing Functions
If f1 and f2 are nondecreasing functions on a closed interval [a, b] then

f1 + f2 is also a non-decreasing function but f1 f2 need not be
The function f := f1 f2 is in the class of functions of bounded variation
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Setup
f : [a, b] R
P = {(x i1 , x i ) : i = 1, . . . , k} partition of [a, b]
P = set of all partitions of [a, b]
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Variation
Definition
Take f : [a, b] R, P = {(x i1 , x i ) : i = 1, . . . , k} a partition of [a, b], and P
is the set of all partitions of [a, b]. The variation Vab ( f ) of f on [a, b] is
Vab ( f
) = sup
k
X
| f (x i ) f (x i1 )| : P P
i=1
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Definition
If Vab ( f ) is finite then f is of bounded variation on [a, b].
Note: If Vab ( f ) = then we say that f has unbounded variation. For example,
Brownian motion has paths of unbounded variation.
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Example 1
Example
If function f is non-decreasing on [a, b], then for any P P :
k
X
i=1
| f (x i ) f (x i1 )| =
k
X
f (x i ) f (x i1 ) = f (b) f (a)
i=1
Therefore,
Vab ( f ) = f (b) f (a).
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Example 2
Example
The function
f (x) =
0,
x =0
sin( 1x ),
x > 0.
f
/ BV[0, 2 ].
1.0
0.5
0.1
0.2
0.3
0.4
0.5
0.6
-0.5
-1.0
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Example 3
Example
The function
f (x) =
x =0
0,
x
sin( 1x ),
x > 0.
f
/ BV[0, 2 ].
0.6
0.4
0.2
0.1
0.2
0.3
0.4
0.5
0.6
-0.2
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Stieltjes Integration
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Stieltjes Integral
Useful in probability theory as it allows one to handle continuous and

discrete random variables using the same theory
The Stieltjes generalisation of Riemann (and Lebesgue) integrals involve
two functions
Integrating one function against the increments of another function
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Stieltjes Sum
Let f : [a, b] R and g : [a, b] R. For any P P , P := {I1 , I2 , . . . , I n } with

I k := (x k1 , x k ) choose points zk [x k1 , x k ] and form the sum
S( f , g; P) :=
n
X
f (zk )(g(x k ) g(x k1 )).
k=1
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Riemann-Stieljes Integral
Definition
If lim|P|0 S( f , g; P) exists, then this limit is called the Riemann-Stieljes integral
of f with respect to g and is denoted
Z b
Z b
f (t) d g(t)
or
f d g.
a
The function f is called the integrand and the function g is called the
integrator.
Note: A Lebesgue-Stieljes integral can also be constructed.
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Linearity in the Integrand
Lemma
If
Rb
a
f1 d g and
Rb
a
( f1 + f2 ) d g =
a
f2 d g exist and , R, then

b
f1 d g +
a
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f2 d g.
a
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Linearity in the Integrator
Lemma
If
Rb
a
f d g1 and
Rb
a
b
f d(g1 + g2 ) =
a
f d g2 exist and , R, then

b
f d g1 +
a
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f d g2 .
a
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Integration by Parts
Lemma
If f integrable with respect to g , then g is integrable with respect to f and
Z b
b Z b

g d f = f g
f d g.
a
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Existence Criteria
Theorem
If f C[a, b] and g BV[a, b] then
Z b
f dg
exists.
Theorem
If f BV[a, b] and g C[a, b], then
Z b
f dg
exists.
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Outlook to Stochastic Integration

We want to be able to integrate a function f against the paths of a Brownian
motion (Wt ) t0 .
However, each path t 7 Wt () is of unbounded variation but continuous
We could potentially write
b
f (t) dWt
a
if f BV[a, b] and use Stieltjes integration. This is called path-by-path

integration.
What about
Z b
Z b
1
sin
dWt or
Wt dWt ?
t
a
a
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A random variable X on a probability space (, F , P) is normally distributed or
Gaussian with parameters and 2 , written as X N(, 2 ), if
x
P{X < x} =
, x R
where is the normal distribution function

Z x
(x) :=
2
p1 e u /2 du.
2
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Characterisation
The moment generating function characterises the class of Gaussian random

variables.
Lemma
A random variable X N(, 2 ) under a measure P if and only if
1
E[e X ] = e + 2
for all real .
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Gaussian Shifts
Lemma (Gaussian shift)

Let X N(0, 1), let h be a measurable function, and c R. Then
E[e cX h(X )] = e c
/2
E[h(X + c)]
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Gaussian Shifts
Example
Take h(x) = 1 then
E[eZ ] = e
/2
Note: Z N(0, 2 )
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Gaussian Shifts
Example
If Z N(0, 1) then X := + Z N(, 2 ) so
E[e X ] = E[e+Z ]
We identify h(x) = e so h(Z) = e and

E[e X ] = E[e+Z ] = E[eZ h(Z)] = e
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/2
e = e+
/2
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Multivariate Random Variables
Consider vector X whose elements are random variables on the same

probability space (, F , P):
X = (X 1 , X 2 , . . . , X n )0
E[X i ] = i and Cov[X i , X j ] = qi j for i, j = 1, . . . , n.
We call the vector := (1 , . . . , n )0 the mean and the matrix
Q := (qi j )ni, j=1 the covariance matrix of X .
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Multivariate Gaussians
Definition
Assume det Q > 0, then the (random) vector X has a multivariate normal
distribution if it has the density
1
1
0 1
(x) = p
exp (x ) Q (x ) , x Rn .
n
2
(2) det Q
We write X N(, Q) if this is the case.
For example: x Rn ,
Z
P{X > x} =
(x 1 , x 2 , . . . , x n ) d x 1 d x 2 d x n .
x1
x2
xn
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Multivariate Gaussians
If Z N(0, Q) and c = (c1 , c2 , . . . , cn )0 Rn then X := c T Z is Gaussian with
X N(0, c 0Qc).
If C Rmn , i.e. a m n matrix, then we have
X = C Z N(0, CQC 0 ),
and CQC 0 is a m m covariance matrix.

Given a Rn , X is alternatively characterized by its moment generating
function
1 0
0X
0
E[e ] = exp Q .
2
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Multivariate Gaussian Shifts
Lemma
Let X N(0, Q), let h be a measurable function of x Rn , and c Rn . Then
0
1 0
E[e c X h(X )] = e 2 c Qc E[h(X + c)]
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Week 2
Brownian Motion
Monte Carlo Method
Simulating Stochastic Processes
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Brownian Motion
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Probability Space
A probability space (, F , P) consists of three parts:
the sample space (the set of all possible outcomes),
the set of events F (each event is a set containing zero or more outcomes),
Example (Coin flip)

= {H, T }. F contains 4 events: {H}, {T }, {} (neither head nor tails) and
{H, T } (either heads or tails). F = {{}, {H}, {T }, {H, T }}. Then
P({}) = 0,
P({H}) = P({T }) =
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1
2
P({H, T }) = 1
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The Set of Events
The set of events F (the set of all subsets of ) is a -algebra as:

F contains the sample space F
F is closed under complements: if A F then ( \ A) F
F is closed under countable unions: if A1 , A2 , . . . F then i Ai F
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Stochastic Processes
Definition
A stochastic process X is a family (X t )0tT of random variables defined on the
same probability space (, F , P) taking values in Rn (the state space).
The process X can be viewed in terms of:
a (random) path t 7 X t ()
the probability distribution of X at some fixed time t , i.e., P{X t < x}.
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Finite-dimensional Distributions
Definition
If X := (X t )0tT is a Rn -valued stochastic process, then for every finite
sequence of times t 1 , t 2 , . . . , t k the probability distribution of the random
variable
X := (X t 1 , X t 2 , . . . , X t k )0
is called the finite-dimensional distribution of X .
Note: Since X is Rn valued and we are evaluating at k times t 1 , . . . , t k then X is
Rnk -dimensional.
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Filtrations and Adaptedness

Definition
Given a probability space (, F , P), a filtration is an increasing collection of
events (F t ) t0 and bounded above by F , i.e.,
Fs F t F ,
s<t
We say that a stochastic process X = (X t ) t0 is adapted to the filtration if, for

every time point t , the random variable X t only relies on the information up
to time t , i.e., F t .
Examples: 2X 1 is adapted to F1 but X 1 is not adapted to F1/2 .
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Brownian Motion
Definition
A stochastic process W := (Wt ) t0 is a called a Brownian motion (under P) if it
has all of the following properties:
1. the paths t 7 Wt () are continuous for P-almost all ;
2. W (0) = 0, P-almost surely;
3. for 0 s < t < , Wt Ws N(0, t s);
4. for k N and 0 t 1 < t 2 < . . . < t k , the increments Wt i+1 Wt i with i < k,
are independent.
We shall denote by F t = (F t ) t0 the natural filtration generated by the
process W : the event set F is generated by all values of Ws up to time s = t .
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Existence
Theorem (Wiener 1923)

Brownian motion exists.
In homage to Norbert Wiener, a Brownian motion is also known as a Wiener
process.
Trivia: Wiener (1894 - 1964) was rejected for a job at University of Melbourne.
Ended up getting a job at MIT where he stayed the rest of his life.
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Simple Properties
The following properties of a Brownian motion W can easily be proved:

Wt N(0, t);
Cov[Ws , Wt ] = min(s, t);
1
E[e Wt ] = e 2 t ;
2
E[Wt4 ] = 3t 2 .
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Invariances
Brownian motion (BM) also has a number of useful invariance properties. In

particular, if W is a BM then so are the following processes:
the reflected process X t := Wt ;
the scaled process X t := 1c Wc 2 t for c > 0;
the stationary process X t := Wt+u Wu for u > 0;
the inverted process X t := tW1/t for t > 0 and X 0 = W0 = 0.
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Donskers Theorem
Theorem (Donsker 1951)
Let (n )nN be a sequence of independent and identically distributed random
variables with E[i ] = 0 and 0 < Var[i ] = 2 < . Let
S0 = 0,
Sn =
n
X
i .
i=1
We construct a sequence of X n of stochastic processes by

X n (t, ) =
1
1
p S[nt] () + (nt [nt]) p [nt]+1 ()
n
n
for t [0, 1], n N. Then this sequence converges (weakly) towards the
Brownian motion B := (B t )0t1 , i.e., we have X n B in probability dist.
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Monte Carlo Method
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Main Idea
The main idea of the Monte Carlo method is to approximate an expected value
E[X ] by an arithmetic average of the results of a big number of independent
experiments which all have the same distribution as X .
Trivia: In 1946, physicists needed to perform complicated calculations for the
Manhattan project. They couldnt solve the problem using standard
mathematical methods. The Mathematician Stanislaw Ulam (1909 - 1984)
suggested using random experiments. Being a secret project, this required a
code name. Von Neumann chose the name Monte Carlo.
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Strong Law of Large Numbers
One of the most powerful theorems of probability theory

Has been a central object of research during the history of the subject
It is the basis of the Monte Carlo method
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Strong Law of Large Numbers

Theorem (SLLN)
If (X n )nN be a sequence of integrable, R-valued random variables that are
independent, identically distributed and defined on the probability space
(, F , P). Let = E[X 1 ]. Then, we have for P-almost all
n
1X
X i ()
n i=1
The arithmetic mean of the (realisations of) X i tends to the theoretical mean
of every X i .
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Crude Monte Carlo Method
Approximate E[X ] by the arithmetic mean

N
1X
X i ()
N i=1
for some finite N N.

Here, the X i () are the results of N independent experiments that the same
probability distribution as X .
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Unbiased Estimator
Theorem
Let (X n )nN be a sequence of integrable R-valued random varaibles that are i.i.d.
as X . Then the Monte Carlo estimator
N
1X
X N :=
Xi,
N i=1
N N,
is an unbiased estimator for = E[X ], i.e., we have

E[X N ] = .
Note: This ensures that the MC Estimator is correct in the mean, it does not
help us get a feel for the absolute value of the error.
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Increasing Accuracy
We look at the standard deviation of the difference between X N and
As
1 X
2
Var[X
]
=
i
N 2 i=1
N
p
the standard deviation is of order O(1/ N )
Var[X N ] = Var[X N ] =
This means that to increase the accuracy of the crude MC estimate by one
digit (i.e., reduce the std. dev by a factor of 0.1) requires increasing N by a
factor of 100.
To acheive higher accuracy, we need a significant effort.
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Central Limit Theorem

Theorem (CLT i.i.d case)
Let (X n )nN be a sequence of i.i.d. R-valued random variables on (, F , P).
Assume that they all have finite variance 2 = Var[X ]. Then, the normalised and
centralised sum of these random variables converges in distribution to the
standard normal distribution:
N
X
1
D
X i N N(0, 1) as N .
p
N i=1
We can infer from the CLT that for large values of N the crude Monte Carlo
estimator is approximately N(, 2 /N )-distributed.
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Approximate Confidence Interval

An approximate (1 )-confidence interval for the expectation is
N
1 X
N
1X

X i z1/2 p ,
X i + z1/2 p
N i=1
N N i=1
N
where z1/2 is the 1 /2-quantile of the standard Normal distribution.

As 97.5%-quantile is about 1.96, an approximate 95% confidence is
N
1 X
N
1X

Xi 2p ,
Xi + 2p
N i=1
N N i=1
N
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Approximate Confidence Interval

Typically, the standard deviation is unknown. We need to estimate 2 by the
sample variance
v
v
u
u
N
N
X
t 1 X
t
N
1
N =
(X i X N )2 =
X i2 X 2N
N 1 i=1
N 1 N i=1
Giving our approximation of 95% confidence
N
1 X
N
N 1 X

Xi 2p ,
Xi + 2pN
N i=1
N N i=1
N
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Calculating
Example ()
The classic example of the Monte Carlo method is calculating the value of .
Consider the part of the unit circle C with center at the origin (0, 0) that
intersects with the positive unit square [0, 1]2 . Our experiment is to randomly
choose points p1 , p2 , . . . , pN of the unit square (i.e., uniformly distributed) and
consider
X i = 1{pi C} .
We have then P(pi C) = /4 as the probability of hitting C is its area r 2 /4
and r = 1. Since
E[1{pi C} ] = P(pi C) = /4
we can estimate by
N
4X
() =
1{pi C} ().
N i=1
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Monte Carlo Integration

Example (MC Integration)
Suppose you wanted to calculate the value of the deterministic n-dimensional
integral of the form
Z
g(x) d x.
[0,1]n
Introduce the density f (x) of the n-dimensional Uniform distribution on

[0, 1]n via
f (x) = 1{x[0,1]n } (x), x Rn
then
I=
g(x) d x =
g(x) f (x) d x = E[g(X )]
[0,1]n
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Monte Carlo Integration

We approximate by
N
1X
I N () =
g(X i ())
N i=1
where X 1 , . . . , X N are all i.i.d. uniformly distributed random variables on [0, 1]n
p
Remark: By the SLLN the rate of convergence is O(1/ N ) but is independent
of the dimension n. As opposed to deterministic quadrature formulas that
have a rate of convergence O(N 2/n ). The MC approximation outperforms
when n > 4.
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In practice, we often need to calculate expected values by the Monte Carlo

method
If X = (X t )0tT is a stochastic process, we often want to calculate
= E[g(X )] = E[g(X t , 0 t T )]
where g is a function of the whole path of X .
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Algorithm for Stochastic Processes
Approximate E[g(X )] by the arithmetic mean

N
1X
g(X i ()).
N i=1
where X 1 , X 2 , . . . are independent replications of paths of the stochastic

process X .
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Special Cases
If the function g only depends on the value of the stochastic process X at a
particular time, i.e., if we have
g(X ) = h(X T )
for a fixed time T and R-valued function h, then we only have to know the
distribution of X T . Either the distribution of X T is known, or we have to
simulate the whole path to get X T .
If g only depends on X at a finite number of times t 1 , t 2 , . . . , t n , i.e.,
g(X ) = h(X t 1 , . . . , X t n )
for some function h then we are in the random variable case.
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General Case
If g cannot be reduced to one of the special cases then we need to simulate

the true path of X . Unfortunately, this is not possible and we need to find
approximation methods. There is no general approach and methods have to
be tailored to the specific problem.
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Simulating Paths: Basics
The fact that the random variables X t for all t s are related to each other
has the consequence that we cannot simply simulate independent
random variables that have the same distribution as the different X t
We have to take care of the relation among the X t which can be extremely
strong
Since the times t [0, T ] are uncountable, we cannot simulate the true
path of the process X . We need to approximate the path at finite times
0 = t1 < t2 < < t n = T
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Algorithm
Let 0 = t 0 < t 1 < < t n = T be a partition of [0, T ]. Let Pk denote the
conditional distribution of X t k given X t k1 . We obtain the approximate path
X () by:
1. Set X 0 () = 0
2. For k = 1 to n do:
(a) Simulate a random number Yk () with Yk Pk
(b) Set X t k () = X t k1 () + Yk ()
(c) Between t k+1 and t k obtain X t via linear interpolation
X t () = X t k1 () +
t t k1
Yk (),
t k t k1
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t (t k1 , t k ).
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Brownian Motion
Let 0 = t 0 < t 1 < < t n = T be a partition of [0, T ]. We obtain the
approximate path t 7 B t () by:
1. Set B0 () = 0
2. For k = 1 to n do:
(a) Simulate a random number
p Zk N(0, 1)
(b) Set B t k () = B t k1 () + t k t k1 Zk
(c) Between t k=1 and t k obtain X t via linear interpolation
B t () = B t k1 () +
t t k1
(B t () B t k1 ()),
t k t k1 k
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t (t k1 , t k ).
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Week 3
Stochastic Integration
Stochastic Differential Equations
Simulating Solutions of SDE
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Stochastic Integration
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Simple Functions
Let F = (F t ) t0 and h an F-adapted process on [0, T ] taking values in R.
Definition
We call h a simple process if for a partition := {0 = t 0 < t 1 < < t n = T }
and F t i -measurable random variables (hi )ni=1 , the process h(t) := h(, t)
satisfies
h(, t) =
n1
X
hi ()1(t i ,t i+1 ] (t)
for 0 t T and
i=0
Note: In the easy case, h is a simple function given by h(t) =

for 0 t T where hi R for i = 1, . . . , n.
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Pn1
i=0
hi 1(t i ,t i+1 ] (t)
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Properties
Simple process and functions allow us to approximate arbitrary processes

and functions
We approximate the area under the curve by rectangles
We build up the concept of stochastic integrals by starting with the case
for simple processes
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Stochastic Integral for Simple Processes
Definition
The stochastic integral (aka. It integral) of a simple process h is defined as
Z T
n1
X
hi ()(Wt i+1 Wt i )
h(t) dWt =
i=0
whenever E[h2i ] < for all i = 0, . . . , n 1.
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Square-integrable Simple Processes
We required E[h2i ] < for all i = 0, . . . , n 1 for the stochastic integral

to exist.
2
We write H[0,T
for the set of all F-adapted simple processes h that satisfy
]
E[h2 ] d t < .
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Properties of Stochastic Integral
Theorem
2
For simple processes h H[0,T
we have
]
Z T
h(t) dWt = 0
1. E
0
2. E
h(t) dWt
E[h(t)2 ] d t
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Proof of 1
Since,
Z
0
h(t) dWt =
n1
X
hi ()(Wt i+1 Wt i )
i=0
taking expectations of both sides and from the fact that

E[Wt i+1 Wt i ] = 0
gives the result.
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Proof of 2
From the definition, we have
Z T
h(t) dWt =
n1
X
hi ()(Wt i+1 Wt i ).
i=0
So
E
h(s) dWs
=E
n1
X
2
hi (Wt i+1 Wt i )
i=0
=E
n1
X
h2i (Wt i+1
Wt i )
i=0
n1
+ 2E
hi h j (Wt i+1 Wt i )(Wt j+1 Wt j )
i, j=0
i6= j
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Proof of 2
For i < j , by the tower property of conditional expectations
E[hi h j (Wt i+1 Wt i )(Wt j+1 Wt j )] = E[hi h j (Wt i+1 Wt i )E[(Wt j+1 Wt j )|F t j ]] = 0
Moreover,
E[h2i (Wt i+1 Wt i )2 ] = E[h2i E[(Wt i+1 Wt i )2 |F t i ]]
= E[h2i ](t i+1 t i )
Substituting, we obtain
n1
Z T
Z
X
2
2
=
E
h(t) dWt
E[hi ](t i+1 t i ) =
0
i=0
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E[h(t)2 ] d t
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Martingales
Definition
A F-adapted stochastic process X := (X t ) t0 is a martingale if E[|X t |] < for
each t > 0 and E[X t |Fs ] = X s for all s t .
The following processes are examples of martingales:
the Brownian motion W ;
X t := Wt2 t ;
E t := exp(cWt 12 c 2 t), where c R.
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Stochastic Integrals as Martingales
Lemma
2
If h is a simple process in H[0,T
, then the process
]
Z
X t :=
h(s) dWs ,
tT
is a martingale.
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Construction
We have seen how to construct stochastic integrals of simple processes

This construction can now be extended to the full stochastic integral
under some conditions on the integrand h
The construction uses the idea that we can approximate the integrand h
by simple processes and then take the limit
The full mathematical proof is about taking care of all the technical
aspects of convergence to the limiting object and existence of this object
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Square-integrable Processes
2
Let h := (h t )0tT be a stochastic process. We say that h is in the set of H[0,T
]
processes if, for all t [0, T ], we have

Z t
|h(s)|2 ds < .
E
0
2
Note: Processes in H[0,T
can be approximated arbitrarily close by simple
]
2
processes in H[0,T ] .
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Construction
Theorem
2
Let W be a BM. For every h H[0,T
the stochastic integral
]
I t (h) :=
h(s) dWs ,
tT
(2)
exists.
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Properties
Let W be a BM. Then the stochastic integral given by (2) has the following
properties:
2
linearity: I t (h + g) = I t (h) + I t (g) for h, g H[0,T
and , R;
]
2
then I is a continuous martingale;
If h H[0,T
]
The It isometry holds:
Z T
2
Z
h(t) dWt =
E
0
E[|h(t)|2 ] d t.
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It Processes
An It process is the sum of an absolutely continuous drift plus a continuous
local martingale of the form
Z t
Z t
X t = X0 +
(s) ds +
(s) dWs ,
(3)
2
where H[0,T
and is a progressively measurable process satisfying
]
Rt
|(s)| ds < for all t > 0, such that the above integrals are defined.
0
We also write
dX t = (t) d t + (t) dWt .
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Identifying Martingales from It Processes
If X is an It process with representation dX t = (t) d t + (t)dWt which

RT
satisfies E[( 0 s2 ds)1/2 ] < , then
X is a martingale X is driftless ( t 0).
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Novikovs Condition
If d X t = t X t dWt for some F -previsible process t , then
Z T
1
2 ds
< X is a martingale.
E exp
2 0 s
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Quadratic covariation
In addition to (3), let
Yt = Y0 +
(s) ds +
(s) dWs ,
be another It process defined in terms of the same Brownian motion W . The

quadratic covariation of the processes X and Y is given by
Z t
X , Y t =
(s)(s) ds,
and X , X is called the quadratic variation of the process X .
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Product Rule
Given X t and Yt adapted to the same Brownian motion W ,
dX t = t dWt + t d t,
dYt = t dWt + t d t.
Then
d(X t Yt ) = X t dYt + Yt dX t + t t d t
In the other case, if X t and Yt are adapted to two different and independent
,
Brownian motions W and W
dX t = t dWt + t d t
t + t d t
dYt = t d W
Then
d(X t Yt ) = X t dYt + Yt d X t
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Let (t, x) and (t, x) be measurable functions of t [a, b] and x R.
Consider the stochastic differential equation (SDE)
d X t = (t, X t ) d t + (t, X t ) dWt ,
X a = R,
(4)
which should be interpreted as the stochastic integral equation

Z t
Z t
Xt = +
(s, X s ) ds +
(s, X s ) dWs ,
a t b.
(5)
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Solutions
A stochastic process X := (X t ) t0 is a (strong) solution to (4) if it satisfies:
The stochastic process (t, X t ) H 2 so that
Z t
(s, X s ) dWs
is a well-defined It integral for each t [a, b];

Almost all sample paths of (t, X t ) satisfy
Z b
|(s, X s )| ds < ;
For each t [a, b], (5) holds almost surely.
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Existence and Uniqueness
To obtain solutions of (4), one needs to impose conditions on the functions

(t, x) and (t, x). Depending on the conditions imposed one can obtain:
existence of (potentially multiple) solutions;
existence of a unique solution;
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Lipschitz and Linear Growth

We say that a measurable function f (t, x) on [a, b] R satisfies the Lipschitz
condition in x if there exists a constant K > 0 such that
| f (t, x) f (t, y)| K|x y|,
a t b, x, y R.
We say that a measurable function f (t, x) on [a, b] R satisfies the Linear

growth condition in x if there exists a constant K > 0 such that
| f (t, x)| K(1 + |x|),
a t b, x R.
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Existence of Unique Solution
Theorem
Suppose that (t, x) and (t, x) satisfy the Lipschitz and linear growth
conditions in x for all t 0. Then for every initial time a R+ and point R,
there exists a unique solution X of the SDE (4).
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Simulating Solutions of SDE
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Overview
As with ODE, most SDE do not admit explicit solutions

Therefore, we need to consider numerical methods to solve them
However, there are fundamental differences between ODE and SDE
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Differences between ODE and SDE
The two main differences between ODE and SDE are:

A solution to an SDE is a (function-valued) random variable, and thus we
obtain different solutions for different .
A (strong) solution to an SDE is not smooth, as the underlying Brownian
motion is not smooth at all.
The second difference means that numerical schemes for ODEs that rely on
this property are not automatically good when adapted to the SDE situation.
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Goal of Approximation
Numerical schemes for SDE depend on our specific goal. Are we interested in
obtaining a path t 7 Xe (t, ) that is as close as possible to the (unknown)
solution path t 7 X (t, ),
or in computing an expectation of a functional E[g(X )] of the SDE?
The first is called strong approximation and the second is weak
approximation.
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Exact Simulation
In some rare cases, we can find an explicit solution to the SDE. For example,
the SDE
dX t = aX t d t + bX t dWt , X 0 = x,
has the explicit solution
1 2
X t = x exp (a b )t + bWt = f (t, Wt )
2
Then calculating E[g(X T )] for some function g : R R is no different from

simulating a random variable.
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Approximating Paths
The task becomes a lot more difficult when we want to calculate the
expectation of the function of the whole path t 7 X t
Even in the case of Brownian motion, we need to find a way to
approximate the path
We follow the same approximation idea: approximate the paths on an
partition of the interval [0, T ] by simulating the Brownian motion on that
partition and then constructing the values of X t on the partition
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Approximating Paths
Theorem
Assume that the SDE
d X t = a(t, X t ) d t + (t, X t ) dWt ,
X0 = x
has an explicit solution of the form X (t) = f (t, Wt ) with f a continuous,

real-valued function. Let Xen be an approximation of X that is constructed by
Xen (t) = f (t, Wt ),
if t = iT /n for some i = 0, 1, . . . , n
and extended to all t [0, T ] by linear interpolation. Then, for each bounded
and continuous function g of the path of X , we have
E[g(Xen )] E[g(X )],
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Strong Approximation
Consider the SDE

d X t = a(t, X t ) d t + (t, X t ) dWt ,
X0 = x
and consider a partition = {0 = t 0 < t 1 < < t n = T } of the interval

[0, T ]. We approximate the SDE by X 0 = x and for i = 0, . . . , n 1 by
X t i+1 = X t i + a(t i , X t i )(t i+1 t i ) + (t i , X t i )(Wt i+1 Wt i ).
This is called the Euler-Maruyama scheme.
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Euler-Maruyama Scheme
Let t := T /N for a given N so that t i = it . Then approximate the SDE by:

1. Set Xe (0) = X (0) = x
2. For i = 0 to N 1 do
(a) Simulate a Zi N(0, 1)
(b) Set
p
Xet i+1 = Xet i + a(t i , Xet i )t + (t i , Xet i ) t Zi
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Week 4
Its Formula
Multidimensional Stochastic Calculus
Stochastic Exponential
Black-Scholes Market
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Its Formula
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Chain Rule
Remember the (calculus) chain rule states that
d
f (g(t)) = f 0 (g(t))g 0 (t)
dt
Or for a function f (t, x t ) in terms of total derivatives
df
f d t f d xt
=
+
dt
t dt x dt
and multiplying throught by d t gives
d f (t, x t ) =
f
f
(t, x t )d t +
(t, x t )d x t
t
x
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Its Formula
Its formula is one of the most useful tools in stochastic calculus

It is a stochastic version of the chain rule
In the stochastic version, we get an extra correction term
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Its Formula for Brownian Motion

Let (Wt ) t0 be a BM. What are the dynamics of f (t, Wt )?
Theorem
For a function f : [0, T ] R such that the partial derivatives
f
2
we have
exist and are continuous and for which x H[0,T
]
f (t, Wt ) f (0, 0) =
Z
0
f
(s, Ws ) dWs +
x
Z
0
f
1
(s, Ws ) ds+
s
2
f
t
, x and x 2
2f
2f
(s, Ws ) ds
x2
Alternatively written:
d f (t, Wt ) =
f
f
12f
(t, Wt ) dWt +
(t, Wt ) d t +
(t, Wt ) d t
x
t
2 x2
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Applications
E[Wtn ]
Solving SDEs
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Its Formula for Processes

Let (X t ) t0 satisfy dX t = (t, X t ) d t + (t, X t ) dWt . What are the dynamics of
f (t, X t )?
Theorem
For a function f (t, x) that is twice differentiable in x and once in t . Then for
Yt = f (t, X t ), we have
d Yt =
f
f
2f
1
(t, X t ) d t +
(t, X t ) dX t + (t, X t )2 2 (t, X t )d t
t
x
2
x
Expanding out the dX t term,

2
f
f
f
1
2 f
(t, X t ) + (t, X t )
(t, X t ) + (t, X t )
(t,
X
)
d
t+(t)
(t, X t ) dWt
t
t
x
2
x2
x
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Multidimensional Stochastic Calculus
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Multidimensional Brownian Motion

Definition
A standard n-dimensional Brownian motion W := (W (t)) t0 is defined as
W1 (t)
W2 (t)
W (t) =
...
Wn (t)
and satisfies the following two properties:

1. Each of the processes (W j (t)) t0 with j = 1, . . . , n, is a one-dimensional
Brownian motion.
2. The Brownian motions Wi and W j are independent for i 6= j and index
values i, j = 1, . . . , n.
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Multidimensional Brownian Motion

Correlation of Brownian motions can be modeled using weighted sums of
independent Brownian motions or multiplication by a covariance matrix.
Example
Let (W1 (t)) t0 and (W2 (t)) t0 be two independent Brownian motions. For
1 +1, let
W (t) = W1 (t) + 1 2 W2 (t).

Then (W (t)) t0 is a Brownian motion and
E(W1 (t) W (t)) = t.
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Multidimensional Stochastic Integration
We would like to extend the idea of stochastic integration to multiple

dimensions.
To handle things like:
Z T
W1 (t) dW2 (t)
or
sin(W12 (t) + W22 (t)) dW2
We will use vectors and matrices.
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2
be the set of Rn -valued adapted processes
Let H[0,T
]
h(t) = [h1 (t) h2 (t) hn (t)]
such that
Z
kh(t)k d t < .
Recall: kxk =
x 12 + x 22 + + x n2 .
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Let h be Rn -valued, (W (t)) t0 be a n-dimensional Brownian motion, and
times S < T .
2
For every h H[0,T
one can define the stochastic integral
]
T
h(t) dW (t) =
I T :=
S
n Z
X
i=1
h j (t) dW j (t).
2
If h H[0,T
then the process (I t ) tS is a martingale and
]
2
h(t) dW (t)
=E
kh(t)k2 d t .
I is one-dimensional in this case (i.e., h a vector).

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Let H be a m n matrix of progressive processes
h11 (t) h1n (t)

.. .
H(t) = ...
.
hm1 (t) hmn (t)
2
then
If hi j H[0,T
]
I =
Z
S
H(t) dW (t) =
h11 (t)
...
h1n (t)
dW1 (t)
.. ..
.
.
hm1 (t) hmn (t)
dWn (t)
In other words, I is a m 1 matrix (i.e., column vector) whose i th element

is given by
n Z T
X
(I )i =
hi j (t) dW (t).
j=1
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Multidimensional Diffusion Processes

Since we have defined multidimensional stochastic integration, we can
now consider multidimensional diffusion processes or It processes.
Of the form
dX t = a(t) d t + b(t) dW (t),
X (0) = x R
where a(t) R, b(t) = [b1 (t) b2 (t) bn (t)] with W an n-dim BM.
Or of the form
d X t = a(t) d t + B(t) dW (t),
X (0) = x Rn
where a(t) Rn , B(t) Rmn , and W an m-dim BM.
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A stochastic differential with drift and diffusion coefficient a and b for X in
component form is given by
dX i (t) = ai (t) d t +
m
X
bi j (t)dW j (t),
j=1
for t in [0, T ] and i = 1, . . . , n.

The corresponding integral form for the components is
Z t
m Z t
X
X i (t) = X i (0) +
ai (s)ds +
bi j (s)dWsj ,
j=1
for t in [0, T ] and i = 1, . . . , n.

The stochastic differential is just an abbreviation for the corresponding
stochastic integral equation.
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The SDE in vector/matrix form is given by
d X (t) = a(t)d t + b(t)dW (t),
X (0) = x Rn
The column vectors X (t), a(t) and W (t) are given by
a1 (t)
X 1 (t)
X (t) = ... , a(t) = ... and W (t) = [W1 (t), . . . , Wm (t)] T .
X n (t)
an (t)
The matrix b(t) is given by
b11 (t) . . .
..
...
b(t) =
.
bn1 (t) . . .
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b1m (t)
.. .
.
bnm (t)
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Quadratic Variation
Consider the n-dimensional It process
Z t
X (t) = X (0) +
a(s) ds +
B(s) dW (s).
The quadratic variation of the component process X i (t), for i = 1, . . . , n, is

the random integral given by
Z t
Bi (s)0 Bi (s)ds
X i t =
where Bi (t) is the i th column of B(t).
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Quadratic Covariation
Consider the n-dimensional It process
Z t
a(s) ds +
X (t) = X (0) +
B(s) dW (s).
The quadratic covariation of the component processes X i and X j , for

i, j = 1, . . . , n, is the random integral given by
Z t
Bi (s)0 B j (s)ds.
X i , X j (t) =
The stochastic differential for X i , X j (t) is denoted by dX i , X j t and
dX i , X j t = Bi (t)0 B j (t) d t.
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Multidimensional It Formula
The multi-dimensional It formula gives the stochastic differential for the
process Y (t) = f (t, X (t)) for some transformation function
f (t, x) = ( f1 (t, x), . . . , f m (t, x))0
The function f is assumed to map from [0, ) Rn Rm and be of class
f (t,x)
2 f (t,x)
C 1,2 (R, Rn ): i.e., the functions (t, x) t and (t, x) x i x j are
continuous on (0, ) Rn for i, j = 1, . . . , n.
Its formula states that the stochastic differential for
Y (t) = (Y1 (t), Y2 (t), . . . , Ym (t))0 for t in [0, T ] is given by
X f (t, X (t))
f k (t, X (t))
k
dt +
d X i (t)
d Yk (t) =
t
x
i
i=1
n
2
X
f k (t, X (t))
1
+
dX i , X j (t).
2 i, j =1 x i x j
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Multidimensional It Formula
The multi-dimensional It formula using drift and diffusion coefficients is
given by
n
f (t, X (t))
f (t, X (t)) X
d Y (t) = d f (t, X (t)) =
ai (t)
+
t
xi
i=1
!
n
2
f
(t,
X
(t))
1 X
bi (t) T b j (t)
+
dt
2 i, j =1
xi x j
n
m
X
X
f (t, X (t))
+
bi j (t)
dW j (t).
x
i
j=1 i=1
This
by substitution of the differentials for d X i (t) and
is obtained

d X i , X j (t) using the covariation form of Its formula.
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Change of Measure
Girsanovs theorem explains how the dynamics change for an

n-dimensional Brownian motion under a change in measure.
The change in measure from P to some other measure Q is related to what
is called the Radon-Nikodym derivative for the two measures.
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Change of Measure
Let (W (t)) t0 be an m-dimensional Brownian motion under P .
Let ( (t)) t0 be an F-adapted n-dimensional diffusion process that
satisfies the Novikov condition.
Then there is a measure Q with the properties:
1. Q is equivalent to P .
f with
2. The process W
Z t
f(t) = W (t) +
(s) ds
W
0
is an m-dimensional BM under Q.
In differential form we have
f(t) = dW (t) + (t)d t.
dW
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Girsanovs Theorem
Theorem (Girsanov)
2
and X satisfy dX t = (t) dWt . If E t (X ) is a uniformly integrable
Let H[0,T
]
martingale with E (X ) > 0 then
n Z T
Z T
X
dQ
1
i (s) dWsi +
= E T (X ) = exp
2i (s) ds
dP
2
0
0
i=1
defines an equivalent probability measure Q P and the process

Z t
f(t) := W (t) +
W
(u) du
0
is a Q-Brownian motion.
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Martingale Representation Theorem

Suppose we have two n-dimensional diffusion processes X (t) and Y (t)
given by
d X (t) = H(t) dW (t)
d Y (t) = F (t) dW (t).
H and F are n n progressive processes.

The martingale representation theorem states that there exists a unique
matrix process (t) = [i j (t)] such that
d Y (t) = (t) dX (t)
or
dYi (t) =
n
X
i j (t)d X j (t).
j=1
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The stochastic exponential of an It process X is defined as
1
E t (X ) = e X t 2 X ,X t
The stochastic exponential E t (X ) has the following properties:

E t := E t (X ) is a positive It process and the unique solution to the SDE
d E t = E t dX t ,
E0 = e X 0 ;
E (X ) is a continuous local martingale if X is a local martingale;

E (0) = 1;
E (X )E (Y ) = E (X + Y )eX ,Y ;
E (X )1 = E (X )eX ,X .
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The Black-Scholes market typically consists of a risky asset S whose price
dynamics is given by the solution of the SDE
dS t = S t ( d t + dWt ),
S0 = 1
and a risk-free asset B with value B t satisfying

dB t = B t r d t
B0 = 1.
Writing dS t = S t d X t with
dX t = d t + dWt ,
X 0 = 0,
it follows from the stochastic exponential that

S t = S0 E (X ) = S0 exp(t 12 2 t).
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Self-financing Portfolios
A portfolio or trading strategy is a pair of processes (, ) that give the amount
of holding at time t of the asset pair (S, B). The value process of this portfolio is
V (t) = (t)S(t) + (t)B(t)
The portfolio is called self-financing for (S, B) if

Z t
|(u)| dSu <
for all t > 0,
and there is no inflow or outflow of capital during the trading. In other words,
the change in value of the portfolio over any time period is only due to the
changes in the value of B and S :
dV (t) = (t)S(t) + (t)B(t).

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Arbitrage Portfolio
A arbitrage portfolio is a self-financing portfolio (, ) with value process V

satisfying
V (0) = 0, V (T ) 0, P{V (T ) > 0} > 0,
for some T > 0.
If no arbitrage portfolio exists then we say that the model is arbitrage-free.
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Martingale Measures
We call a measure Q an equivalent martingale measure to P (EMM), denoted

Q P, if the discounted price process
Z(t) :=
S(t)
B(t)
is a Q-martingale.
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Fundamental Theorem of Asset Pricing

Theorem
Let Q be the EMM. Suppose we have a contingent claim X T F T . If
EQ [X T2 ] < then the claim is replicable and the value at time t of any
replicating portfolio is given by
Vt = B t EQ [B T1 X T |F t ].
In particular, under the Black-Scholes model, the fair price at time zero for the
option is
V0 = EQ [er T X T ]
fT ) where W
f is a Q-BM.
where X T = f (S T ) and S T = S0 exp((r 21 2 )T + W
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Week 5
Black-Scholes Model
Definition of Implied Volatility
Empirical Observations
Arbitrage Bounds
Asymptotics
Approximating Implied Volatility
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Black-Scholes Model
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Black-Scholes Model
Black-Scholes Model
Under real-world measure P, we assume there exists deterministic r , , and
such that
B t = exp(r t)
S t = S exp(Wt + t),
where r is the risk-free interest rate, is the stock volatility and is the stock
drift, and S := S0 is the current stock price.
There are no transaction costs and both instruments are freely and
instantaneously tradable either long or short at the price quoted.
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Black-Scholes Formula
Explicit solution was obtained by Black and Scholes (1973) relying heavily on
the notion of no-arbitrage in Merton (1973).
Black-Scholes-Merton (BSM) Formula

C = S(d1 ) er T K(d2 )
where
log( KS ) + (r 12 2 )T
d2 :=
,
p
T
p
d1 := d2 + T
Jointly awarded Nobel prize in economics in 1997.
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Benchmark Model
Widely acknowledged that assumptions underlying the BSM model are far
from realistic
BSM model enjoys unrivalled popularity in practice due to its role as a
benchmark model
Provides a convenient mapping device from the space of option prices to a
single real number called implied volatility (IV)
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Definition of Implied Volatility
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Implied Volatility
Unknown parameter in the BSM formula is : the volatility

Backed out of market option prices, IV gives a straight-forward
comparison of the relative expensiveness of options across various strikes,
expiries, and underlying assets.
It is interesting to plot IV against relative strikes and time to expiry
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Dale Roberts (c) 2011-2014Fig.
Matthias R. Fengler
IV Surface
100 %
80 %
60 %
40 %
20 %
0.5
1
1.5
2
Moneyness [X/S]
Time to maturity [years]
1. IV surface of DAX index

from 28
Oct. 2008, traded at the EUREX.
Lastoptions
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08:19
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IV Smile and Term Structure
The function resulting for a fixed expiry is frequently called the implied
volatility smile due to the U-shaped pattern
For a fixed strike across several expiries one speaks of the term structure of
implied volatility
Practioners like to think of them as stemming from a smooth and
well-behaved surface
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Applications
Market makers use the IV surface to quote prices for strike-expiry pairs
which are illiquid or not listed
Pricing engines used to price exotic options are calibrated against the IV
surface
Risk managers use stress scenarios defined on IV surface to visualise and
quantify the risk inherent to option portfolios
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Formal Definition
Concept of IV was first introduced by Latan and Rendelman (1976).
Definition
Given an observed market price of European option Ce with strike K and time
to maturity T , the implied volatility of this option is
e:
e ) Ce = 0
C (K, T,
e R+ .
By monotonicity of the BSM price in , there exists a unique solution
Put options can also be used (Put-Call Parity).
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IV Surface
e is just a constant. However, given the same underlying asset, it varies

The IV
across strikes K and expiry T .
Definition
An implied volatility surface is the mapping
e : (t, K, T ) 7
e t (K, T ).
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IV surfaces can be observed for indices, stocks, etc.

Different asset classes may display different features: smiles may be more
shallow, symmetric or even upward-sloping
Smiles are very pronounced for short expiries and become flattish for
longer dated options
This has not always been the case. Strong asymmetry appeared after the
1987 market turmoil
For equity options (indices and stocks), the smile is negatively skewed
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Implied Volatility Skew

We call m := log(K/S) the log moneyness.
Definition
We define the implied volatility skew as

e 2
m m=0
The skew often increases during times of crisis (e.g., dot-com crash 2001-2003,
Sept. 11 2001, GFC 2008).
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Further Empirical Observations
When expiry is small, the fluctuations of the skew are larger

The IV term structure is typically upward sloping (i.e., increasing levels of
IV for longer dated options) in calm times, while in times of crisis it is
downward sloping with short-dated options having higher levels of IV
than longer dated ones
Returns of IV and returns of underlying asset are negatively correlated
IV appears to be mean-reverting (though this is hard to show statistically)
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BSM implied volatility
Time Series of ATM-IV

45 %
1Y ATMIV
DAX
8000
40 %
7000
35 %
6000
30 %
5000
25 %
4000
20 %
3000
15 %
2001
2003
2005
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2007
2009
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Dale Roberts (c) 2011-2014 Fig.
Matthias R. Fengler
Time Series of IV Skew
0.2
50
0.6
1M skew
1Y skew
0.8
IV term structure
40
30
20
1.2
10
IV term structure
Skew
0.4
1.4
0
1.6
2001
2003
2005
Time
2007
2009
3. Time series of 1M and

IV 14/10/2014
skew (left
Last1Y
Modified:
08:19 axis, gray line and black line
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implied volatility
Empirical Quantiles ofBSMATM-IV
0
0.1
0.2
Skew
0.3
0.4
0.5
95%
75%
Median
25%
5%
0.6
0.7
0.8
0.9
1M 3M
1Y
Time to expiry
2Y
Fig. 4. Empirical quantiles

of the ATM IV skew as a function of time to expiry.
!
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2
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Arbitrage Bounds
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Arbitrage Bounds on IV Surface

IV cannot simply take any value due to constraints imposed by the
no-arbitrage principles. For IV, these are very difficult to write down, but easily
stated indirectly in the option price domain.
Arbitrage Bounds
e must be such that the call price is bounded above and below:
The IV
e) S
(S er T K)+ C (K, T,
The call price must be decreasing and convex function in K :

er T
C
e) 0
(K, T,
K
and
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2C
e) 0
(K, T,
K2
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Arbitrage Bounds on IV Surface

The quantity x := K/F T is called forward-moneyness where F T is the price of
the forward with expiry T .
Calendar Arbitrage Bounds

Let T1 < T2 be the expiry dates of two call options whose strike prices K1 and
K2 are related by forward-moneyness, i.e. x 1 = x 2 . Then
e 2 ) C (K1 , T1 ,
e 1)
C (K2 , T2 ,
must hold.
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Asymptotics
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Asymptotics
Asymptotics are mathematical results obtained when you take one of the
variables to infinity or to zero
These types of results provide interesting theoretical information about
the model
They are often easier to establish and help reduce the complexity
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Asymptotics for the IV Surface
Many results were conjectures until recently

Understanding the behaviour of IV for far expiries and far strikes is of utter
importance for extrapolation problems often arising in practice
These results are model independent
m = log(K/S) is the (simple) log-moneyness
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IV Surface Flattens
The first theorem shows that the IV surface flattens for infinitely large expiries.
Theorem (Rogers and Tehranchi 2009)

For any M > 0 we have
lim
sup
T m ,m [M ,M ]
1
2
e (m1 , T )| = 0.
|e
(m2 , T )
Note: sup means supremum which is equivalent to the maximum if there are
finitely many elements in the set.
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Flattening Rate
The rate of flattening of the IV skew can be made more precise by the following
result.
Theorem (Rogers and Tehranchi 2009)

1. For any 0 m1 < m2 , we have
e (m2 , T )2
e (m1 , T )2
m2 m1
T
2. For any m1 < m2 0,

e (m2 , T )2
e (m1 , T )2
m2 m1
T
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Representation Formula
The level of the IV for far expiry can be written in terms of the expected share
price.
Theorem (Tehranchi 2009)

For any M > 0, we have

v

t
8

e (m, T ) log E[S T 1] = 0
lim
sup
T m[M ,M ]

T
Note: a b := min(a, b).
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At Short Expiry
Theorem (Roper and Rutkowski 2009)
If C (K, ) = (S K)+ for some > 0 then
e (K, T ) = 0.
lim
T 0+
Otherwise,
p
2C (K, T )
,
p
S T
e (K, T ) =
lim
T 0+
| log(S/K)|
,
p
2T log(C (K, T ) (S K)+ )
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S=K
S 6= K
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At Short Expiry
The asymptotics are different when S = K and S 6= K

The ATM case is similar to Brenner and Subrahmanyam approximation
formula
The limit does not need to exist
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At Far Strike
Lee has established a one-to-one correspondance between the large-strike tail
and the number of moments of S T and the small-strike tail and the number of
moments of S T1 .
Theorem (Lee 2004)

1+p
Define e
p := sup{p : E[S T ] < } and
R = lim sup
m
Then R [0, 2] and

e
p=
e2
|m|/T
R 1
1
+
.
2R
8
2
Equivalently,
R = 2 4( e
p2 + e
pe
p).
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At Far Strike
Theorem (Lee 2004)
q
Define e
q := sup{p : E[S T ] < } and
L = lim sup
m
Then L [0, 2] and

e
q=
e2
|m|/T
1
1
+ L .
2 L
8
2
Equivalently,
L = 2 4( e
q2 + e
qe
q).
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Approximating Implied Volatility
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Approximation Formulas
There is no closed-form formula for IV, even for European options

e (e.g., Goal Seek in Excel)
A numerical solver has to be used to find
Approximation formulas can be useful when you dont have a solver
(Spreadsheet)
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BSF Approximation
The simplest approximation to IV is due to Brenner and Subrahmanyam (1988)
and Feinstein (1988).
BSF Approximation
e
v
t 2 C
T S
This formula is only accurate when S = Ker T .
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Li Approximation
A more accurate formula was proposed by Li (2005) and hold for ITM (S K )
and OTM (S K ) options.
Li Approximation
q
2z T2 p1T 8z 2 p62z

1
4(KS)2
2
p
+ S(S+K)
2 T
where z = cos( 31 arccos( p332 )), :=

:= |Ker T S|SC 2 .
p
2
S+K (2C
if 1.4
if > 1.4
+ Ker T S) and
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Corrado-Miller Approximation
Other approximation formulas often lack a rigourous mathematical
foundation. The most prominent amongst these are those suggested by
Corrado and Miller (1996) and Bharadia et al. (1996)
Corrado-Miller Approximation
v
p
u
2
1
2
SX t
SX
(S X )2
ep
C
+
C
2
2
T S+X
where X = Ker T .
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Bharadia et al. Approximation
Bharadia et al. Approximation

v
t 2 C (S X )/2
e
.
T S (S K)/2
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Accuracy of Approximations
Isengildina-Massa et al. (2007) investigate the accuracy of six

approximation formulas
According to their criteria, Corrado and Miller (1996) is the best, followed
by Li (2005) and Bharadia et al. (1996)
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Week 5b
Bonds
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Bonds
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Types of Bonds
A bond is a securitized form of a loan

The buyer of the bond lends the issuer an initial price P in return for a
predetermined sequence of payments
The payments may be fixed in nominal terms or linked to some index (e.g.,
CPI)
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Types of Bonds
In UK, government bonds are called gilt-edged securities (gilts)

Most other countries: treasury bills or treasury notes
In Australia: Treasury Fixed Coupon Bonds and Treasury Capital Indexed
Bonds
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RBA Treasury Fixed Coupon Bonds
Pays interest on a semi-annual basis at the prescribed coupon rate,

applied to the face value
At maturity, the face value amount is repaid
More details:
http://www.aofm.gov.au/content/_download/Treasury_Bond_
Information_Memo_18_December_2009.pdf
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Treasury Capital Indexed Bonds
Pays interest on a quarterly basis at the prescribed coupon rate, applied to

the face value
However, the face value is adjusted by indexing the principal to inflation
At maturity, investors receive the adjusted capital value of the security
More details:
http://www.aofm.gov.au/content/_download/Treasury_
Indexed_Bond_Information_Memo_18_December_2009.pdf
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Australian Bonds (small investors)
Subject to availability, a range of series across different maturity dates will

be on sale at any one time.
Applications may be made for amounts of $1,000 face value and in
multiples of $1,000 up to $250,000 per investor per day (all series
combined).
Indicative prices:
http://www.rba.gov.au/fin-services/bond-facility/xls/
otc-prices.xls
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Types of Bonds
Bonds are also issued by state government (NSW, QLD, etc), banks, and
companies
Bonds issued by companies are called corporate bonds
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Types of Bonds
Some corporate bonds trade on the ASX (here)

Some are OTC like BHP bonds (here)
Australias corporate bond market is very small compared to the US or
Europe
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Types of Bonds
Bonds with identical characteristics but sold by different issuers may have
different prices
Example: 2 bonds of 20Y with 6% coupon, one issued by a company and
one issued by RBA
Bond issued by company will probably trade at a lower price because
market participants take into account the possibility of default on the
payments or the redemption process
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Types of Bonds
We will not consider or model credit risk in this course

We only model risk-free government bonds
Government bonds are not always riskless: think about Greece and US at
the moment
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Fixed Coupon Bonds
We will only concentrate on fixed coupon (fixed-interest) government

bonds that have no probability of default
We pay a price P for a bond in return for a stream of payments c1 , c2 , . . . , cn
at times t 1 , t 2 , . . . , t n from now
The amount of the payments are fixed at the time of issue
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Pays interest on a semi-annual basis at the prescribed coupon rate,

applied to the face value
At maturity, the face value amount is repaid
More details:
http://www.aofm.gov.au/content/_download/Treasury_Bond_
Information_Memo_18_December_2009.pdf
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Notation
g : coupon rate per 100 nominal

n: number of coupon payments
t (or ): fixed time between payments
t 1 : time of first payment ( t 1 t )
t j = t j1 + t for j = 2, . . . , n
t n : time to redemption
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Interest is paid on semi-annual basis: t = = 0.5

We assume Australian Government will not default: P(T, T ) = 1 for all T
We assume that RBA offers all maturities T
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Fixed Coupon Bonds
first coupon
0
if bond has gone ex-dividend
c j = gt for j = 2, . . . , n 1
cn = 100 + gt
c1 =
gt
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Clean and Dirty Prices
Bond prices are often quoted in two different forms

The dirty price is the actual amount paid in return for the right to the full
amount of each future coupon payment and the redemption proceeds
The clean price is an artificial price which is typically quoted in the market
place
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Dirty price
Assume semi-annual (twice a year) coupon payments

If the bond has gone ex-div, then the dirty price will give the buyer the
right to the full coupon payable in just over six months
But not the coupon due in a few days
The dirty price of a bond will drop by an amount approximately equal to a
coupon payment at the time it goes ex-div
The dirty price of a bond typically rises steadily in between ex-div dates
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RBA Prices
Banks selling price includes coupon interest accrued since the last
coupon payment and up to the date of purchase
Purchasers of Bonds subsequently receive a full coupon payment when it
next falls due, irrespective of when the purchase takes place in the coupon
period.
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RBA Prices
The only exception to this is when Bonds are purchased during the
ex-interest period, which commences seven days prior to a coupon
payment date. Investors who purchase Bonds during the ex-interest
period do not receive the impending coupon payment.
As a result, Bond prices in the ex-interest period do not include accrued
interest and are commensurately lower.
Question: Are RBA prices clean or dirty?
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Zero-Coupon Bonds
A ZCB is a bond with a coupon rate of zero and a nominal value of 1

We denote the price at time t of a ZCB that matures at time T by P(t, T )
Sometimes we call this a T -ZCB or T -bond
Note that the value of $1 due immediately is P(t, t) = 1 for all t
Arbitrage arguments give P(t, T ) 1 for all T
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ZCB Cash Flow
P(t, T )
t
1
T
P(t, T )
t
1
T
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Modelling Assumptions
There exists a frictionless market for T -bonds for every T > 0

P(T, T ) = 1 for all T
P(t, T ) is differentiable in T
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Term structure
Price P(t, T )
1
0
Years
T 7 P(t, T )
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T -Bond Price Process

1
0
Years
t 7 P(t, T )
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Modelling Assumptions
In reality these assumptions are not always satisfied

Zero-coupon bonds are not traded for all maturities
It might happen that P(T, T ) 1 if the issuer defaults
The condition that P(t, T ) is differentiable in T is purely technical: it
ensures that T 7 P(t, T ) is a smooth curve
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Simple vs. Continuous Compounding

Compounding Rate
1
R
2
R/2
m
R/m
..
..
.
.
eR = 1 + R + o(R)
t =0
1
1
1
..
.
t =1
1+R
(1 + R/2)2
(1 + R/m)m
..
.
eR
for small R
e0.04 = 1.04081 but e0.04 1.04081 = 8.1bp
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Week 6
Interest Rates
Arbitrage-Free Pricing
The Interest Rate Setting
Blacks model
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Interest Rates
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Spot Rates
The spot rate at time t for maturity at time T is defined as the yield to
maturity of the T -bond:
R(t, T ) =
In other words,
log P(t, T )
Tt

P(t, T ) = exp (T t)R(t, T )
If we invest $1 at time t in the T -bond for T t years, then this will

accumulate at an average rate of R(t, T ) over the whole period
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Forward Rates
The forward rate at time t which applies between times T and S

(t T < S) is defined as
F (t, T, S) =
1
P(t, T )
log
ST
P(t, S)
The forward rate arises from a contract: agree at time t that we will invest
$1 at time T in return for e(ST )F (t,T,S) at time S
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No-arbitrage argument
e (ST )F (t,T ,S)
By definition, contract has value zero at time t provided F (t, T, S) is the fair
forward rate between T and S
We argue that:
F (t, T, S) =
P(t, T )
1
log
ST
P(t, S)
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Suppose this is not true and that
F (t, T, S) >
1
P(t, T )
log
ST
P(t, S)
Then setup a portfolio at time t :
Units
Value
Forward
+1
0
T -Bond
+1
P(t, T )
S -Bond P(t, T )/P(t, S) P(t, T )
0
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Hold the contracts until maturity of the Forward

At time T the portfolio is worth 0
At time S , the portfolio is worth
e(ST )F (t,T,S)
P(t, T )
>0
P(t, S)
We have an arbitrage: we started with a portfolio with value 0 at time t

and have a sure profit at S
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Hence, we cannot have
F (t, T, S) >
1
P(t, T )
log
ST
P(t, S)
By reversing the argument, we cannot have

F (t, T, S) <
1
P(t, T )
log
ST
P(t, S)
F (t, T, S) =
P(t, T )
1
log
ST
P(t, S)
We conclude that
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Forward-rate curve
The instantaneous forward rate curve (or forward-rate curve) at time t is

for t < T given by
f (t, T ) = lim F (t, T, S)
ST
..
.
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Forward-rate curve
lim F (t, T, S) =
ST
log P(t, T )
T
T P(t, T )
P(t, T )
Therefore,
P(t, T ) = exp
f (t, u) du
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Forward-rate curve
f (t, u)
A=
RT
t
f (t, u) du
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Forward-rate curve
F (t, u, u + )
u u+
f (t, u) = lim F (t, u, u + )

0
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Forward Rates
It is a lot easier to work with the instantaneous forward-rate f (t, T ) than

the forward F (t, T, S) between T and S
The forward curve T 7 f (t, T ) is positive for all T t
This implies that P(t, T ) is a decreasing function of T
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Short Rate
R(t, T ) is the risk-free rate of interest over the fixed period from t to T
When we talk about the risk-free rate of interest we mean the
instantaneous risk-free rate:
r(t) = lim R(t, T ) = R(t, t) = f (t, t)
T t
Think of r(t) as the rate of interest on a bank account: this can change on
a daily basis
r(t) is often called the short rate
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Short Rate
R(t, T )
r (t)
t
tT
r (t) = limT t R(t, T )
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Proxies for Short Rate
The short rate r(t) is fundamental to no-arbitrage pricing

However, it can not be directly observed
The overnight interest rate is not usually considered a good proxy for r(t)
Some people use a slightly longer rate as a proxy: the seven-day
Eurodollar rate
Ideally, you want to use a liquid security as a proxy
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Par Yields
The par-yield curve (t, T ) specifies the coupon rates,

100(t, T ),
at which new bonds should be priced if they are to be issued at par

Price of 100 per 100 nominal
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Par Yields
Par yield for a maturity T (annual coupons, = 1), solve following
equation for coupon rates (t, T ):
100 = 100(t, T )
T
X
P(t, s) + 100P(t, T )
s=t+1
Solution given by
1 P(t, T )
(t, T ) = P T
s=t+1 P(t, s)
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Yield to Maturity
Yield to maturity usually applies to coupon bonds

It is the internal rate of interest (IRR) of the bond
Given the price of a bond P , coupons c1 , c2 , . . ., then
find :
P(t, T ) =
n
X
c j e(t j t)
j=1
is the YTM
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Relationships
For a given t , each of the curves P(t, T ), f (t, T ) and R(t, T ) uniquely
determines the other two
Recall that we have
P(t, T ) = exp (R(t, T )(T t))

Z T
= exp
f (t, u) du
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Relationships
f (t, u)
R(t, T )
A = R(t, T )(T t) =
RT
t
f (t, u) du
P(t, T ) = exp(A)
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Example
T
F (0, T, T + 1)
0
1
2
3
0.0420 0.0500 0.0550 0.0560
P(0, T ) = exp
T 1
X
F (0, t, t + 1)
t=0
T
P(0, T )
0
1
2
3
0.95887 0.91211 0.86239 0.81628
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Example
R(0, T ) =
T
F (0, T, T + 1)
P(0, T )
R(0, T )
log P(0, T )
T +1
0
1
2
3
0.0420 0.0500 0.0550 0.0560
0.95887 0.91211 0.86239 0.81628
0.0420 0.0460 0.0490 0.05075
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Arbitrage-Free Pricing
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Arbitrage
We are able to construct at time 0 some portfolio which has a NPV of zero
At some fixed time T > 0, the portfolio gives us a sure profit
This is sometimes called a free lunch
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Arbitrage
The concept of arbitrage becomes clear when we consider static portfolios

Also known as buy-and-hold strategies
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Arbitrage with Static Portfolios
Suppose we can invest in n assets

Asset i has price Pi (t) at time t
Asset i pays no dividend or coupons
We have x i units of asset i in our portfolio
Portfolio value is
V (t) =
n
X
x i Pi (t)
i=1
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Arbitrage with Static Portfolios
At time t = 0:
V (0) =
n
X
x i Pi (0) = 0
i=1
At time T > 0:
P(V (T ) 0) = 1
P(V (T ) > 0) > 0
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Principle of No Arbitrage
The Principle of No Arbitrage states simply that such arbitrage

opportunities do not exist
If they did exist, smart investors could make infinite amounts of money
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Equivalent Forms for PNA
We cannot construct a riskless portfolio which returns more than the

risk-free rate of return
If two portfolios A and B give rise to identical (but possibly random) future
cashflows with certainty, then A and B must have the same value at the
present time (aka. law of one price)
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Example: Parallel Yield Curve Shifts
It is easy to find a model which admits arbitrage

Suppose that
P(0, T ) = exp
f (0, u) du
for some initial forward-rate curve f (0, T )
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Probability space (, F , P)
Our model is defined so that at time 1 the forward rate curve will be
f (1, u) = f (0, u) + ,
for u > 1
: R is a random variable
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u 7 f (0, u)
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u 7 f (1, u)
{
u 7 f (0, u)
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u 7 f (1, u)
u 7 f (0, u)
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{
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Suppose exists: T1 -Bond, T2 -Bond, T3 -Bond with 1 < T1 < T2 < T3
$1
T1
$1
T2
$1
T3
Let x i be the units held at time 0 of the Ti -Bond
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At time t = 1 we have
P(1, T ) = exp
f (1, u) du
( f (0, u) + ) du
= exp
= exp
f (0, u) du e(T 1)
P(0, T ) (T 1)
e
P(0, 1)
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Remember this for later:
P(1, T ) =
P(0, T ) (T 1)
e
P(0, 1)
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For an arbitrage, we need:
3
X
x i P(0, Ti ) = 0
i=1
3
X
x i P(1, Ti ) 0 with prob. 1
i=1
3
X
x i P(1, Ti ) > 0 with positive prob.
i=1
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The value of the portfolio at time 1 is
V1 () =
=
=
3
X
i=1
3
X
x i P(1, Ti )
xi
P(0, Ti ) (Ti 1)
e
P(0, 1)
by (6)
i=1
(T2 1)
e
g()
P(0, 1)
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Where
g() =
3
X
x i P(0, Ti )e(Ti T2 )
i=1
The trick is to choose time T2 , add/substract T2 , to get
e(Ti 1) = e(Ti T2 ) e(T2 1)
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If value of initial portfolio is zero,
3
X
x i P(0, Ti ) = 0
i=1
then g(0) = 0
Also, at time 1 and for a shift ,
V1 () < 0 g() < 0
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As
g() =
3
X
x i P(0, Ti )e(Ti T2 )
i=1
g() is continuous and twice differentiable in

We are looking for the situation where V1 () > 0 for all 6= 0
As g(0) = 0, we must also have g 0 (0) = 0
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The condition g 0 (0) = 0 implies
3
X
x i (T2 Ti )P(0, Ti ) = 0
i=1
Which, in turn, implies

3
X
x i Ti P(0, Ti ) = 0
i=1
since T2
3
X
x i P(0, Ti ) = 0
i=1
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Finally, it is sufficient that g 00 () > 0 for all to ensure that g() > 0 for all
6= 0
As
00
g () =
3
X
x i (T2 Ti )2 P(0, Ti )e(Ti T2 )
i=1
g () > 0 for all if and only if x 1 and x 3 are both greater than or equal to
0
00
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Take x 2 = 1
Eq (6) and x 2 = 1 imply that at least one of x 1 and x 3 must be greater
than zero
But
3
X
x i Ti P(0, Ti ) = 0
i=1
implies that x 1 and x 3 must be both positive or both negative

It follows that g 00 () > 0 for all
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Hence, g() > 0 for all 6= 0

We can conclude that
V1 () =
3
X
x i P(1, Ti ) > 0
i=1
for all 6= 0
Arbitrage!
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Example 2
Suppose that P(0, t) = e0.08t for all t > 0

And
P(1, t + 1) =
e0.1t
e
0.06t
if = 1
if = 0
for the random variable : {0, 1}

Spot and forward rate curves will randomly shift up or down by 2%
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Example 2
Suppose we hold x 1 , x 2 , x 3 units of T1 -Bond, T2 -Bond, and T3 -Bond such

that
x 2 P(0, 2) = 1
x 1 P(0, 1) + x 2 P(0, 2) + x 3 P(0, 3) = 0

x 1 P(0, 1) + 2x 2 P(0, 2) + 3x 3 P(0, 3) = 0
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Example 2
Solving the system of equations:
1
= 1.173511
P(0, 2)
1
x3 =
= 0.635624
2P(0, 3)
1
x1 =
= 0.541644
2P(0, 1)
x2 =
At time 1, the value of this portfolio is 0.00021 if = 1 or 0.00022 if = 0
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Example 2
The model is not arbitrage-free

It violates the law of one price
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Conclusion
Parallel shifts of the yield curve cannot occur at any time in the future
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Suppose that the risk-free rate r(t) is stochastic
Randomness is underpinned by the probability space (, F , P)
P is the real-world probability measure
The cash account is given by
B(t) = B(0)ex p
Z

r(s) ds
And satisfies d B(t) = r(t)B(t) d t
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Theorem (FTAP)
(i) Bond prices evolve in arbitrage-free manner if and only if exists measure Q
)
equivalent to P under which P(t,T
B(t) is a martingale for 0 < t < T
(ii) If (i) holds, then the market is complete if and only if Q is the unique
)
measure under which P(t,T
B(t) are martingales
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The measure Q is often called the equivalent martingale measure

It is also called risk-neutral measure
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Corollary
Hence
P(t, T ) = EQ exp

r(s) ds F t
where F t is the -algebra generated by the price histories up to time t , and EQ

is the expectation with respect to Q
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X is some F T -measurable claim payable at T

V (t) is fair value of X at time t
Then V (t)/B(t) is also a martingale under Q
Hence,
V (t) = EQ exp

r(u) du X F t
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Example: Forward Pricing
Forward contract: K will be paid at time T in return for repayment of 1 at

time S where T < S
Equivalently, K is paid at T in return for delivery of an S -bond with value
P(T, S)
How much is this contract worth at time t < T ?
X = P(T, S) K at time T
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V (t) = EQ exp
= EQ e
RT
r(u) du

r(u) du X F t
h
RS
i i

F T F t
i
r(u) du
EQ e

h RT
t r(u) du
KEQ e
F t
i
i
h RS
h RT

= EQ e t r(u) du F t KEQ e t r(u) du F t
t
= P(t, S) K P(t, T )
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We now choose K so that V (t) = 0

This gives
K=
P(t, S)
P(t, T )
The contract can be hedged at no cost at time t by buying one unit of

P(t, S) and selling P(t, S)/P(t, T ) units of P(t, T )
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What is special about the interest rate setting?

There are a few new things to think about...
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Factors
A one-factor model is one under which there is only one source of

randomness affecting the bond prices
In a one-factor model all price changes are perfectly (but non-linearly)
correlated
If we know one change in quantity (e.g. risk-free rate r(t)) we know the
change in all asset prices
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Factors
A multifactor model has multiple sources of randomness

Price changes are not perfectly correlated
Example: m bonds, each bond driven by a different Brownian motion
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A Bond is a Derivative
A bond is a derivative itself

In a one-factor model, the price of any bond is derived from our
knowledge of the short-rate r(t)
The short-rate is the underlying
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Types Of Model
There are two main types of models: Equilibrium and No-arbitrage

Equilibrium models are built on assumptions about how the economy
works
Take into account the varying risk preferences of different investors
Relationship between the economy and the term-structure of interest
rates
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Types Of Model
This means constructing a simple stochastic model for the evolution of

the risk-free rate
Invoke the FTAP to derive theoretical bond prices
theoretical prices evolve in a way that is arbitrage-free
It may happen that theoretical prices is different from the observed prices
in the market, giving rise to arbitrage opportunities (cheap/dear analysis)
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Types Of Model
Often short-rate models are seen as equilibrium models

This is not always true
It is difficult to prove that a short-rate model has an equilibrium derivation
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Types Of Model
No-Arbitrage Models use the observed term structure at the current time
as the starting point
Future prices evolve in a way which is consistent with this initial price
structure and which is arbitrage free
These models are used to price short-term derivatives
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Types Of Model
Actual vs. theoretical price differences in equilibrium models get

magnified when pricing derivatives
A 1% error could lead to a 10% error in the price of an option
On the other hand, no-arbitrage models have strange dynamics for
quantities like r(t) in the long-term which are hard to justify
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Blacks model
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Types Of Model
Black, F. (1976). The pricing of commodity contracts. Journal of Financial

Economics.
Assumed that futures prices have the same lognormal property assumed
for stock prices
Gives us Black-Scholes style formula for valuing futures options
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Blacks formula is given by

C = er t (F0 (d1 ) K(d2 ))
P = er t (K(d2 ) F0 (d1 ))
where
log(F0 /K) + 2 T /2
d1 =
,
p
T
p
log(F0 /K) 2 T /2
d2 =
= d1 T .
p
T
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Example
European put future option on crude oil. TTM is 4 months, current futures
price is $20, exercise price is $20, risk-free rate is 5% per annum, and the
volatility of the futures price is 25% per annum.
F0 = 20,
K = 20, r = 0.05, T = 4/12, = 0.25.

p
p
T
T
log(F0 /K) = 0, d1 =
= 0.07216, d2 =
= 0.07216.
2
2
(d1 ) = 0.4712, (d2 ) = 0.5288
V = e0.054/12 (20 0.5288 20 0.4712) = 1.12
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Blacks model for a Bond option
Traders became comfortable with the lognormal assumption and

volatility to describe uncertainty
This lead to the formula being applied to interest rate derivatives (Bond
options, interest rate caps, and swap options)
During 1980s and 1990s, the volume of trading in interest rate derivatives
in both over-the-counter and exchange-traded markets increased very
quickly
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Consider a European call option on a variable whose value is V . Define:

T:
F:
F0 :
K:
P(t, T ):
VT :
:
Maturity of the option

Forward price of V for a contract with maturity T
Value of F at time zero
Strike price of the option
Price at time t of a zero-coupon bond paying $1 at time T
Value of V at time T
Volatility of F
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Blacks model assumes:

1. VT has a lognormal
distribution with standard deviation of log VT
p
equal to T
2. The expected value of VT is F0
Discounts the expected payoff by multiplying by P(0, T )
European call payoff is max(VT K, 0) at time T
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Lognormal assumption implies that the expected payoff is
E(VT )(d1 ) K(d2 )
where E(VT ) is the expected value of VT and

log(E(VT )/K) + 2 T /2
d1 =
,
p
T
p
d2 = d1 T .
This gives
C = P(0, T ) (F0 (d1 ) K(d2 )) ,
P = P(0, T ) (K(d2 ) F0 (d1 ))
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Blacks model can be extended to allow for the situation where the payoff
is calculated at time T but the payoff is actually made at some time S > T
This basically changes the discounting:
C = P(0, S) (F0 (d1 ) K(d2 )) ,
P = P(0, S) (K(d2 ) F0 (d1 ))
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Blacks model does not assume that the evolution of V or F is driven by a

(geometric) Brownian motion
All that is required is that VT is lognormally distributed at time T
is referred to as the volatility of F or the forward volatility of V
doesnt say anything about the standard deviation of log V at times
other than T
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Validity of Blacks model
Blacks model is appropriate when interest rates are constant or

deterministic
In this situation, the forward price of V equal its futures price
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When interest rates are stochastic Blacks model involves two approximations:
E(VT ) = F0 . In a risk-neutral world, E(VT ) is equal to its futures price. The
forward price and futures price are not the same when interest rates are
stochastic
The stochastic behaviour of interest rates is not taken into account for the
discounting
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It is inappropriate to price interest rate derivatives by just modelling the

dynamics of underlying security
Consistent pricing must be based on the evolution of the entire term
structure of interest rates
Using Blacks model navely can lead to arbitrage opportunities
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Week 7
Continuous-Time Interest Rate Models

The Martingale Approach
The PDE Approach
Additional Comments
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Continuous-Time Interest Rate Models
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One-Factor Models for the Risk-Free Rate
Continuous-time setting
One-factor models for the term structure of interest rates
Bond pricing given a one-factor diffusion model for the risk-free rate r(t)
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We assume that r(t) is modelled by

d r(t) = a(t)d t + b(t)dW (t)
(W (t)) t0 is a standard Brownian motion under the real-world probability
measure P
a(t) and b(t) are previsible processes
F t = ({W (s) : s t}) is the -algebra generated by the history of W (s)
up to time t
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a(t) = a(r(t)) and b(t) = b(r(t))

Ensures that r(t) is Markov and time homogeneous
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Model
a(r)
Merton (1973)
Dothan (1978)
r
Vasicek (1977)
( r)
CIR (1985)
( r)
Pearson-Sun (1994)
( r)
Brenann-Schwartz (1979)
( r)
Black-Karasinski (1991)
r r log r
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b(r)
p r
r
r
r
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Model r(t) 0?
AR?
Simple Formula?
M
N
N
Y
D
Y
N
N
V
N
Y
Y
CIR
Y
Y
Y
PS
Y if > 0
Y
N
BS
Y
Y
N
BK
Y
Y ( > 0)
N
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All models are approximation to reality but some are better than others
One must consider:
Desired characteristics
Ease of implementation
How well does model approximate reality
Fast vs. slow calculation
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Sometimes simple formula doesnt mean fast calculation

Ex: analytical formulae exist for CIR however involve using the law of the
non-central chi-squared distribution
In R: dchisq,pchisq,rchisq
Ex: Vasicek and other models only require Normal distribution
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Other Characteristics
Are bond and derivative prices straightforward and simple to calculate

numerically?
Is the model flexible enough to cope with new and more complex
derivative products?
Does the model produce dynamics which are realistic?
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Does the model fit historical data well? (e.g., mean and variance)
If the model keeps rates positive, does it allow forward rates, spot rates
and par yields to take values close to zero?
Does the model have equilibrium derivation?
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One factor models generally fail many of these criteria

This is due to their dependence on a single-factor (e.g., dynamics of r(t))
This is why we will consider multi-factor models in the second half of
semester
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Over the next couple of weeks we will consider one-factor models

We will consider a number of concepts that will carry over to the
multi-factor setting
We will consider a general approach to pricing whereby we obtain a
coherent set of price dynamics that do not admit arbitrage
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We will now discuss the Martingale approach to pricing
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We consider an abstract model with only one source of randomness
Risk-free rate r(t)
P(t, T ) is price of T -bond at time t
d P(t, T ) = P(t, T )[m(t, T )d t + S(t, T )dW (t)]
a(t), b(t), m(t, T ) and S(t, T ) are previsible functions (possibly
stochastic)
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We also have the risk-free cash account B(t)

B(t) satisfies the SDE
dB(t) = r(t)B(t)d t
The solution is
B(t) = B(0) exp
Z

r(u) du
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The risk premium at time t on the risky bond P(t, T ) is defined as the
excess expected rate of return on the bond m(t, T ) over the risk-free rate
of interest r(t)
The risk premium represents the extra reward we get for investing in the
risky asset rather than the risk-free cash account
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The market price of risk is the previsible process

(t) =
m(t, T ) r(t)
S(t, T )
The market price of risk represents the excess expected return per unit of
volatility
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Consider a claim X S at some time S < T

What is the no-arbitrage price, V (t), at time t < S for this claim?
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Theorem
There exists a measure Q P with
V (t) = EQ exp

r(u) du X F t
f(t) and W
f(t) is a BM under Q
where d r(t) = (a(t) (t)b(t))d t + b(t)d W
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In Baxter and Rennie, we had a 3 step approach

Cairns expands this to 5 steps
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Proof
Define the discounted price process

Z t
P(t, T )
Z(t, T ) =
r(u) du
= P(t, T ) exp
B(t)
0
where B(t) is the risk-free cash account B(0) = 1
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Proof
1.
2.
3.
4.
5.
Establish the probability measure Q equiv. to P s.t. Z(t, T ) is a martingale

For t < S < T define D(t) = EQ [B(S)1 X |F t ]
Apply MRT to get holdings (t)
Set (t) = D(t) (t)Z(t, T ), show that portfolio is self-financing
Show that portfolio replicates claim X
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Proof: Step 1
Apply product rule to

Z(t, T ) =
P(t, T )
= B(t)1 P(t, T )
B(t)
to get
d Z(t, T ) = B(t)1 d P(t, T ) + P(t, T )d(B(t)1 ) + dB 1 , P(t)
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Proof: Step 1
Apply Its formula:

1
1 2
dB(t)
+
dB(t)
B(t)2
2 B(t)3
r(t)
=
dt
B(t)
d(B(t)1 ) =
as d B(t) = r(t)B(t)d t and dB(t) = 0d t
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Proof: Step 1
Substituting d P(t, T ) = P(t, T )[m(t, T )d t + S(t, T )dW (t)] and d(B(t)1 )

into product formula gives
r(t)P(t, T )d t
P(t, T )
(m(t, T )d t + S(t, T )dW (t))
+ 0d t
B(t)
B(t)
= Z(t, T )[(m(t, T ) r(t))d t + S(t, T )dW (t)]
d Z(t, T ) =
as
dB 1 , P(t) = 0 d t
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Proof: Step 1
Recall that the market price of risk is
(t) =
m(t, T ) r(t)
S(t, T )
so defining
f(t) = W (t) +
W
(u) du
f(t) = dW (t) + (t) d t

dW
d Z(t, T ) = Z(t, T )[(m(t, T ) r(t))d t + S(t, T )dW (t)]
= Z(t, T )[(m(t, T )r(t)(t)S(t, T ))d t +S(t, T )(dW (t)+(t)d t)]

f(t)]
= Z(t, T )[(m(t, T ) r(t) (t)S(t, T ))d t + S(t, T )d W
f(t)
= Z(t, T )S(t, T )d W
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Proof: Step 1
Notice that Z(t, T ) is an exponential process

We need the Novikov condition to hold, i.e.,
Z T
1
EP exp
(u)2 du <
2 0
so we can apply Girsanovs theorem
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Proof: Step 1
Girsanovs theorem allows us to state that there exists a measure Q
equivalent to P
With Radon-Nikodm derivative given by
Z T
Z T
1
dQ
(u)dW (u)
(u)2 du
= exp
dP
2 0
0
Under which
f(t) = W (t) +
W
(u) du
is a standard Brownian motion
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Proof: Step 1
Note that under the same change of measure from P to Q we have that
d P(t, T ) = P(t, T )[m(t, T ) d t + S(t, T ) dW (t)],
under P
becomes
f(t)],
d P(t, T ) = P(t, T )[r(t) d t + S(t, T ) d W
under Q
Under Q, all T -bond prices have drift equal to the risk-free rate r(t)
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Proof: Step 1
The process Z(t, T ) under Q satisfies

f(t)
d Z(t, T ) = Z(t, T )S(t, T ) d W
The SDE has no drift
The SDE is a martingale under Q if
Z T
1
2
EQ exp
S(t, T ) d t
<
2 0
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Proof: Step 2
We have the claim X S = X that is a random variable

We need to make it into a process
For t < S < T define
D(t) = EQ [B(S)1 X S |F t ]
This is a martingale under Q by the tower property for conditional
expectations
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Proof: Step 3
Z(t, T ) and D(t) are both Q-Martingales

We can apply the Martingale representation theorem (MRT)
By MRT, there exists a previsible process (t) such that
Z t
D(t) = D(0) +
(u)d Z(u, T )
This requires S(t, T ) to be non-zero for all t < S almost surely
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Proof: Step 4
We setup a (P, B) portfolio with value

V (t) = (t)P(t, T ) + (t)B(t)
We take (t) = D(t) (t)Z(t, T )
We need to show that the portfolio is self-financing
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Proof: Step 4
Consider a short time interval [t, t + d t)
Over the period, hold (t) of P(s, t) and (t) of B(s)
The change of value over [t, t + d t) is
(t)d P(t, T ) + (t)d B(t)
We will now compute the change of value of V (t) but
V (t) = (t)P(t, T ) + (t)B(t) = B(t)[(t)Z(t, T ) + (t)] = B(t)D(t)
as (t) = D(t) (t)Z(t, T )
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Proof: Step 4
d V (t) = d[B(t)D(t)]
= B(t)d D(t) + D(t)dB(t) + dB(t)d D(t)
= B(t)(t)d Z(t, T ) + D(t)r(t)B(t)d t + 0d t
f(t) + ((t)Z(t, T ) + (t))r(t)B(t)d t
= (t)B(t)S(t, T )Z(t, T )d W
f(t)) + (t)r(t)B(t) d t
= (t)P(t, T )(r(t)d t + S(t, T )d W
= (t)d P(t, T ) + (t)dB(t)
The portfolio process is self-financing
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Proof: Step 5
We also have
V (S) = B(S)EQ [B(S)1 X S |FS ] = X S
So the portfolio replicates the claim X S

It follows that for t < S , V (t) is the unique no-arbitrage price at time t for
X S payable at S
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Proof: Step 5
V (t) = B(t)D(t)

B(t)
= EQ
X S F t
B(S)
ZS
= EQ exp

r(u) du X S F t
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Uniqueness of the price V (t) is due to:

We are considering a one-factor model
We specified the dynamics under P for P(t, T ) which allows us to establish
a market price of risk
Randomness is driven by a Brownian motion W (t). Other processes (e.g.,
jumps) may mean that V (t) is not uniquely determined
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Corollary
For all S such that 0 < S < T ,
P(t, S) = EQ exp

r(u) du F t
Proof.
Take X S = 1 in previous theorem.
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Under Q the prices of all tradable assets have the risk-free rate of interest
as the expected growth rate
Under P,
d V (t) = V (t)[(r(t) + (t)V (t)) d t + V (t)dW (t)]
(t)V (t) is called the market risk premium or risk premium
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Notice that (t)V (t) depends on the market price of risk (t)
This implies that the risk premiums on different assets are closely linked
They can differ only through the volatility in the tradable asset (V (t) or
S(t, T ) for a ZCB)
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We anticipate that ZCB will have a positive risk premium ((t)S(t, T ) > 0
for all T > t ) to reward for the extra risk
Derivatives V (t) for which V (t) has the same sign as S(t, T ) also have a
positive risk premium (e.g., call option on P(t, T ))
Opposite sign for V (t) leads to a negative risk premium (e.g., Put option
on P(t, T ))
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The PDE Approach
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The PDE Approach
We shall now discuss the Partial Differential Equation (PDE) approach

given in Vasicek (1977)
Previously, we have used the martingale approach to pricing
The PDE approach is also useful especially for numerical methods
Black and Scholes used a PDE approach in their classic paper
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The PDE Approach
r(t) is Markov, i.e., the future dynamics of r(t) given its current value is
independent of past behaviour
The market is efficient: no transactions costs and investors are rational
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The PDE Approach
Our abstract model for r(t) is of the form

d r(t) = a(t, r(t))d t + b(t, r(t))dW (t)
Prices changes for all bonds with different maturities are perfectly (but
nonlinearly) correlated
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The PDE Approach

By assumption P(t, T ) is only a function of the current time t and r(t), i.e.,
P(t, T ) = f (t, r(t))
for some unknown f (t, x)

By Its formula,
f
f
1 2f
dt +
d r(t) + b2 2 d t
t
x
2 x
f
f
1 2f
=
dt +
(ad t + bdW (t)) + b2 2 d t
x
2 x
t

2
f
f
f
1 f
=
+a
+ b2 2 d t + b
dW (t)
t
x 2 x
x
d f (t, r(t)) =
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The PDE Approach

As f (t, r(t)) = P(t, T ), this implies that the price dynamics are given by
an exponential SDE
d P(t, T ) = P(t, T )[m(t, T )d t + S(t, T )dW (t)]
With average price returns

1 P
P 1 2 2P
m(t, T ) =
+a
+ b
P t
r 2 r2
And price returns volatility
S(t, T ) =
1 P
b
P r
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The PDE Approach
We can now consider the market price of risk and use it to derive an
equation for price of a T -bond
Construct a portfolio of:
V1 (t) of a T1 -bond (i.e., short)
V2 (t) of a T2 -bond (i.e., long) with T2 > T1
Total portfolio worth is V (t) = V2 (t) V1 (t)
We now vary V1 (t) and V2 (t) so that V (t) remains risk-free
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The PDE Approach

The instantaneous investment gain from t to t + d t is
d P(t, T1 )
d P(t, T2 )
+ V2 (t)
P(t, T1 )
P(t, T2 )
= V1 (t)(m1 d t + S1 dW ) + V2 (t)(m2 d t + S2 dW )
V1 (t)
= (V2 m2 V1 m1 )d t + (V2 S2 V1 S1 )dW

Where for i = 1, 2:
mi = m(t, Ti ),
Si = S(t, Ti )
We now simplify that expression under some assumptions
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The PDE Approach

If we assume that
Then we get
V1 (t) S(t, T2 ) S2
=
=
V2 (t) S(t, T1 ) S1
V1 (t)S1 V2 (t)S2 = 0
and
V2 m2 V1 m1 =
S1 V
S V
m2 2
m1
S1 S2
S1 S2
So the investment gain over [t, t + d t] is
m2 S1 m1 S2
V (t)
dt
S1 S2
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The PDE Approach
Therefore, through our choice of portfolio strategy we have obtained a

risk-free investment strategy
Further, by varying V1 (t) appropriately we can ensure that this portfolio is
also self-financing:
m2 S1 m1 S2
dV (t) = V (t)
dt
S1 S2
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The PDE Approach

Since the portfolio is risk-free, the principle of no-arbitrage states that the
growth rate must equal r(t):
m2 S1 m1 S2
m1 r
m r
= r(t) or
= 2
S1 S2
S1
S2
This must be true for all maturities. Thus for all T > t
m(t, T ) r(t)
= (t)
S(t, T )
(t) is the market price of risk and cannot depend on the maturity date T
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The PDE Approach

On one hand, we have
m(t, T ) = r(t) + (t)S(t, T )
On the other hand,

P 1 2 2P
1 P
+a
+ b
m(t, T ) =
P t
r 2 r2
1 P
S(t, T ) = b
P r
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The PDE Approach
We equate the two expressions for m(t, T ) to find
P
P 1 2 2P
rP = 0
+ (a b)
+ b
t
r 2 r2
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The PDE Approach

Theorem (Feynman-Kac Formula)
Let T > 0 and be a continuous function. Suppose that a function F (t, r)
satisfies
1 2
2
t F (t, r) + f (t, r) r F (t, r) + (t, r) r F (t, r) r F (t, r) = 0
2
F (T, r) = (r)
Then1 M (t) = exp(
Rt
0
r(u) du)F (t, r(t)) is a martingale and
F (t, r(t)) = EQ exp

r (u) du (r(T ))F t
f
where r (t) = r(t) and under Q satisfies dr (t) = f (t, r )d t + (t, r )d W
1
under some technical conditions, see appendix
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The PDE Approach
We now apply the Feynmann-Kac formula with F (t, r) = P(t, T )

f (t, r) = a(t, r) (t)b(t, r),
(t, r) = b(t, r)
And terminal condition P(T, T ) = (r(t)) = 1 as we are pricing a T -bond

Hence,
P(t, T ) = EQ exp
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r (u) du F t
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The PDE Approach
Under P we have
Under Q we have
f(t)
dr (t) = f (t, r (t))d t + (t, r (t))d W
We need to satisfy ourselves that these measures P and Q are equivalent
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The PDE Approach
Assume that (t) satisfies Novikov condition

R
f(t) = W (t) + t (s) ds
Define W
0
f is a
Then by Girsanovs theorem, there exists Q equiv. to P under which W
BM with Radon-Nikodym derivative
Z T
Z T
dQ
1
= exp
(t)dW (t)
(t)2 d t
dP
2 0
0
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The PDE Approach

We then have
d P(t, T ) = P(t, T )(m(t, T )d t + S(t, T )dW )
f (t)d t)]
= P(t, T )[m(t, T )d t + S(t, T )(d W
f]
= P(t, T )[(m(t, T ) (t)S(t, T ))d t + S(t, T )d W
f]
= P(t, T )[r(t)d t + S(t, T )d W
Thus under Q, the expected return on any bond is the risk-free rate
This implies that Q is the EMM
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The PDE Approach
This Feymann-Kac approach can be applied to other derivative payoffs

Simply choose the function appropriately
This is the basis of finite difference methods for pricing options as we
determine P(t, T ) by solving a PDE with a specific terminal condition
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Additional Comments
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Market Price of Risk
Note that we started by specifying P dynamics and then moved to Q

dynamics using the market price of risk (t)
The market price of risk links the dynamics of the cash bond B(t) and the
T -bond prices
We cant replicate a payoff X only using the cash bond B(t) therefore one
needs to specify
A short-rate model is not fully determined under P unless one specifies the
market price of risk
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Start under Risk-Neutral Measure

It is customary from a modelling point-of-view to simply specify the Q
dynamics of r directly
This implies the Q dynamics of all bond prices by the formula
Z T
P(t, T ) = EQ exp
r(u) du
t
Some people back out the market price of risk by statistical methods
from historical observations of price movements
This is actually wrong... statistical observations are under P
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Week 8
Particular Models
Affine Short-Rate Models
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Particular Models
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The Vasicek Model
The Vasicek model is specified under Q by

f(t)
d r(t) = ( r(t)) d t + d W
f(t) is BM under EMM Q and , , are all positive constants
where W
is the risk-neutral long-term mean risk-free rate
is the rate at which r(t) reverts back to
is the local volatility of the short-term interest rates
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The Vasicek Model

For s > 0, r(t + s) given r(t) is Normally distributed under Q with mean
+ (r(t) )es
and variance
1 e2s
2
This implies that the long-term standard deviation of r(t) is
p
2
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Bond Prices in Vasicek Model

Theorem
Prices for T -bonds in the Vasicek model are given by
P(t, T ) = exp[A(t, T ) B(t, T )r(t)]
where
B(t, T ) =
1 e(T t)

2
2
A(t, T ) = (B(t, T ) (T t)) 2
B(t, T )2
2
4
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European Options in Vasicek Model

Theorem
The price of a European call option on a S -bond with strike price K and exercise
date T ( T < S ) is
V (t) = P(t, S)(d1 ) K P(t, T )(d2 )
where
p
1
P(t, S)
+
, d2 = d1 p
log
p
K P(t, T )
2
v
t 1 e2(T t)
p = (1 e(ST ) )
d1 =
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The Cox-Ingersoll-Ross Model
The Vasicek model has a major problem: the risk-free rate can become
negative
Further, empirical evidence shows that the volatility of r(t) is not constant
but is an increasing function of r(t)
The first tractable model that fixed these problems was the CIR model:
f(t)
d r(t) = ( r(t)) d t + r(t)d W
f is BM under EMM Q
where , , > 0 and W
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Bond Prices in CIR Model

Theorem
Prices for T -bonds in the CIR model are given by
P(t, T ) = exp[A(t, T ) B(t, T )r(t)]
where
2(et 1)
B(t, T ) =
( + )(et 1) + 2

2
2e(+)t/2
A(t, T ) = 2 log
( + )(et 1) + 2
p
= 2 + 22
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European Option Prices in CIR Model
Prices of European options are given in terms of the non-central

chi-squared distribution under Q
They involve a pretty nasty formula
Exercise: Implement the pricing formula in R
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Calibration of Vasicek and CIR Model
In Vasicek and CIR, T -bond prices are given by

P(t, T ) = exp(A(t, T ) B(t, T )r(t))
where A and B depend on the model parameter vector

For Vasicek model: = (, , )
For CIR model: = (, , )
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(0, Ti ) for the Ti -bond with

We have the current market YTMs denoted R
i = 1, . . . , n
We can plot the yield curve (i.e., the term structure)
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2.8%
2.4%
2.0%
Yield
3.2%
3M
6M
1Y
2Y
5Y
10Y
20Y
Time To Maturity (Log Scale)
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Recall that the yield to maturity R(t, T ) satisfies
P(t, T ) = exp((T t)R(t, T ))
We also have
P(t, T ) = exp(A(t, T ) B(t, T )r(t))
Equating the two terms and setting t = 0 we get
1
R(0, T ) = (A(0, T ) B(0, T )r(0))
T
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We now choose the parameter vector to minimize the squared distance

(0, Ti ) and the theoretical yields R(0, Ti ):
between the market yields R
n
X

R
(0, Ti ) R(0, Ti )2
min
i=1
We are fitting the model under Q

We do not fit to historical data! Historical data gives the past dynamics
under P
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2.8%
2.4%
2.0%
Yield
3.2%
3M
6M
1Y
2Y
5Y
10Y
20Y
Time To Maturity (Log Scale)
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The Vasicek and CIR models are equilibrium models

They are nice and simple: we can obtain formulas for prices
The disadvantage of equilibrium models is that they do no automatically
fit todays term structure
Can you trust the price of a bond option when the model does not price
the underlying bond correctly?
A 1% error in the price of the underlying bond could lead to a 25% error in
an option price
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A hedge fund might view the difference between the model prices and the
market prices as the market is mispricing certain assets and build a
trading strategy to capture the mispricings
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There exist models that fit the current market perfectly: they are called
no-arbitrage models (e.g., Ho & Lee, Hull & White)
In an equilibrium model, todays term structure of interest rates is an
output
In a no-arbitrage model, todays term structure of interest is an input
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Affine Short-Rate Models
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Affine Models
We have seen that both the Vasicek and CIR models have T -bond prices
that have the affine form
P(t, T ) = exp(A(t, T ) B(t, T )r(t))
An affine transformation in mathematics is a linear transformation
followed by a translation (i.e., x 7 B x + a).
The form of A and B depend on the model
Q: Are there any other models that have an affine form for P(t, T )?
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Affine Models
Consider the abstract SDE for r(t)
f(t)
d r(t) = m(t, r(t))d t + s(t, r(t))d W
f is a BM under EMM Q
where W
Suppose that
P(t, T ) = exp(A(t, T ) B(t, T )r(t))
Apply Its formula with f (t, x) = exp(A(t, T ) B(t, T )x) to get
A B
1 2
f(t)
d P(t, T ) = P(t, T )
r(t) Bm + Bs d t Bsd W
t
t
2
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Affine Models
But under Q, we know that
f(t)]
d P(t, T ) = P(t, T )[r(t)d t + S(t, T )d W
where S(t, T ) is the volatility of P(t, T )

This follows as all tradable assets must have expected returns given by the
risk-free rate r(t) under Q
Set
1
A B
G(t, r) :=
r(t) Bm(t, r) + Bs(t, r)2

t
t
2
We need G(t, r) = r(t) for all t and r . Equivalently,
g(t, r) := G(t, r) r(t) = 0,
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t, r
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Affine Models
Now, to ensure this holds we need
2
2
2g
2 m(t, r) 1
2 (s(t, r) )
= B(t, T )
+ B(t, T )
=0
r2
r2
2
r2
Clearly we need B(t, T ) 6= 0 for all t, T which implies

2 m(t, r) 1
2 (s(t, r)2 )
+ B(t, T )
=0
r2
2
r2
Hence we conclude
2 (s(t, r)2 )
=0
r2
and
2 m(t, r)
=0
r2
Linear functions f (x) = a + bx satisfy f 00 (x) = 0 for all x
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Affine Models
Theorem
If the drift and volatility of r(t) take the form
m(t, r(t)) = a(t) + b(t)r(t)
and
s(t, r(t)) =
(t)r(t) + (r)
this is sufficient for P(t, T ) to have the affine form

P(t, T ) = exp(A(t, T ) B(t, T )r(t))
where a(t), b(t), (t) and (t) are deterministic functions
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Affine Models
Example (Vasicek Model)

= 0, = 2 , b = and a = which gives
f(t).
d r(t) = ( r(t))d t + d W
We already know it has the affine form.
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Affine Models
Example (CIR Model)

= 0, = 2 , b = , and a = which gives
f(t).
d r(t) = ( r(t))d t + r(t)d W
Again, we already know it has the affine form.
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Affine Models
Example (Merton Model)
= 0, = 2 , b = 0 which gives
f(t)
d r(t) = ad t + d W
and we can determine

B(t, T ) = T t
1
1
A(t, T ) = 2 (T t)3 a(T t)2
6
2
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Affine Models
Example (Pearson and Sun Model)
= 2 , = /2 , b = and a = ( + ) which gives
f(t).
d r(t) = ( r(t))d t + r(t) d W
Note:
This model is similar to CIR
Now, the minimum value for r(t) is
One can derive A(t, T ) and B(t, T ) in terms of the A and B from the CIR
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Week 9
No-Arbitrage Models
The Heath-Jarrow-Morton (HJM) Framework
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No-Arbitrage Models
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Introduction
We shall now consider the class of no-arbitrage models

We saw that with the Vasicek and CIR models, our theoretical prices do not
match all the bond prices we observe in the market
By design, no-arbitrage models take the observed prices in the market as
an input into the model
This means that the theoretical prices P(t, T ) match the observed prices
Pobs (t, T ) at the time of calibration t
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Introduction
Market practitioners prefer no-arbitrage models over equilibrium models
Market makers need to both buy and sell at quoted prices. If their pricing
model gives different prices than the rest of the market then this will give
rise to arbitrage opportunities against the market maker
No-arbitrage models allow market makers to check market scenarios (e.g.,
what happens to other prices if the short-term rate increases?)
Market makers are typically considered with the pricing and hedging of
short-term claims. No-arbitrage models work well in this situation
Banks typically want to price OTC derivatives in a way which is consistent
with the closest-matching traded derivatives
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Markov Models
We shall consider models for which:

the current bond prices in the market are an input
the probability law of P(s, T ) given F t where t s < T is the same as
P(s, T ) given the current value of the short-rate r(t)
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Affine Term Structures
Recall that a model is called affine if the T -bond prices are given by
P(t, T ) = exp (A(t, T ) B(t, T )r(t))
for functions A and B

Some no-arbitrage models are also affine
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Affine Term Structures

Theorem
Given an affine short-rate model
d r(t) = (b(t) + (t)r(t))d t +
f(t)
a(t) + (t)r(t)d W
then the functions A and B satisfy the system of ODE:

1
t A(t, T ) = a(t)B 2 (t, T ) + b(t)B(t, T ),
A(T, T ) = 0,
2
1
t B(t, T ) = (t)B 2 (t, T ) (t)B(t, T ) 1, B(T, T ) = 0.
2
and
P(t, T ) = exp (A(t, T ) B(t, T )r(t))
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Ho and Lee Model

In 1986, Ho and Lee considered the model
f(t)
d r(t) = (t)d t + d W
f(t) is a BM under the EMM Q
where W
This is a more general version of the Merton model where the drift (t) is
now a function of time
We also have the current term structure as an input:
P(0, T ) for all T > 0
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Ho and Lee Model

Ho and Lee model is
f(t)
d r(t) = (t)d t + d W
So in the affine term structure theorem:
b(t) = (t),
(t) = 0,
a(t) = 2 ,
(t) = 0
To find A and B , we need to solve the ODE:
1
t A(t, T ) = 2 B 2 (t, T ) + (t)B(t, T ), A(T, T ) = 0,
2
t B(t, T ) = 1,
B(T, T ) = 0.
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Ho and Lee Model

Set g(s) := B(s, T ) and integrate g 0 (s) = s B(s, T ) from t to T :
Z T
Z T
g 0 (s) ds =
1 ds
t
Use the boundary condition B(T, T ) = 0 to get
g(T ) g(t) = (T t)
B(t, T ) = T t
=0
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Ho and Lee Model

By integrating s A(s, T ) from t to T :
Z T
Z T
Z T
1 2 2
s A(s, T ) ds =
B (s, T ) ds +
(s)B(s, T ) ds
2
t
t
t
Substituting B(t, T ) = T t and using the condition B(T, T ) = 0 we get
Z T
Z T
1 2
A(t, T ) =
(T s)2 ds
(s)(T s) ds
2
t
t
Z T
2
=
(T t)3 +
(s)(T s) ds
6
t
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Ho and Lee Model
Hence, T -bond prices in the Ho and Lee model are given by

P(t, T ) = exp (A(t, T ) B(t, T )r(t))
with
B(t, T ) = T t
2
A(t, T ) =
(T t)3
6
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(s)(T s) ds
t
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Ho and Lee Model

In an affine model, T -bond prices are given by
P(t, T ) = exp (A(t, T ) B(t, T )r(t))
The forward curve is given by
log P(t, T )
T
=
[A(t, T ) B(t, T )r(t)]
T
f (t, T ) =
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Ho and Lee Model

For the Ho and Lee model, we have
T B(t, T )r(t) = r(t)
2
T A(t, T ) =
(T t)2 +
2
Hence,
2
f (t, T ) = (T t)2 +
2
(s) ds
t
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(s) ds + r(t)
t
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Ho and Lee Model

Suppose we have all the market prices Pobs (0, T ) for T > 0
Then we have the market forward curve
fobs (0, T ) =
log Pobs (0, T )

T
And our theoretical forward curve

2
f (0, T ) = T 2 +
2
(s) ds + r(0)
Q: How do we calibrate our model so that f (0, T ) = fobs (0, T )?
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Ho and Lee Model

We now choose
(s) :=
Then
(s) ds =
Z
0
fobs (0, s) + 2 s
s
fobs (0, s) ds +
s
2 s ds
= fobs (0, T ) fobs (0, 0) + 2 T 2

= fobs (0, T ) r(0) + 2 T 2
We now have that
f (0, T ) = fobs (0, T )
Our theoretical forward curve matches the market forward curve exactly!
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Ho and Lee Model

Given a forward curve f (t, T ) at time t , our T -bond prices are given by
Z T
P(t, T ) = exp
f (t, u) du
In the Ho and Lee model, by integrating we get

T
P(t, T ) = exp
fobs (0, u) du + fobs (0, u)(T t)

t

2
2
t(T t) (T t)r(t)
2
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Ho and Lee Model

The solution of the short-rate SDE
f(t)
d r(t) = (t)d t + d W
is easily found to be
r(t) = r(0) +
f(t)
(s) ds + W
With our choice of (s) :=
2
s f obs (0, s) + s
we get
2 t 2
f(t)
r(t) = fobs (0, t) +
+ W
2
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Ho and Lee Model
This means that r(t) fluctuates along a modified initial forward curve
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Hull and White Model
In 1990, Hull and White proposed a generalisation of the Vasicek model

given by
f(t),
d r(t) = ((t)
r(t)) d t + d W
f(t) is a BM under Q and (t) is a deterministic function of time
where W
In the Vasicek model, (t) = is constant
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This is an affine model with
b(t) = (t),
(t) = ,
a(t) = 2 ,
(t) = 0
We get the same B(t, T ) as the Vasicek model:

B(t, T ) =

1
1 e(T t)
Similar to the Ho and Lee model, by integrating:

Z T
Z T
2
2
A(t, T ) =
B (s, T ) ds +
(s)B(s, T ) ds
2 t
t
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The theoretical initial forward curve is
f (0, T ) = T A(0, T ) + T B(0, T )r(0)
Notice that

1
1 e(T t) = e(T t)
t B(t, T ) = e(T t)
T B(t, T ) = T
Hence,
T B(s, T ) = s B(s, T )
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We now get
f (0, T ) = T A(0, T ) + T B(0, T )r(0)
Z T
Z T
2
2
=
s B (s, T )ds + (s) T B(s, T )ds + T B(0, T )r(0)
2 0
0
Z T
2
e(T s) (s)ds + eT r(0)

= B 2 (0, T ) +
2
0
Z T
2
= 2 (1 eT )2 +
e(T s) (s)ds + eT r(0)
2
0
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We now want to fit this model to the forward curve observed in the
market: fobs (0, T )
If we choose
(s) =
1
2
s fobs (0, s) + fobs (0, t) + 2 (1 et )2
then we get
f (0, T ) = fobs (0, T )
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From the properties of the Ornstein-Uhlenbeck process, the short-rate r(t)
evolves like
Z t
Z t
t
(ts)
f(s)
r(t) = e r(0) +
e
(s) ds +
e(ts) d W
0
As
e(ts) (s) ds = fobs (0, t) et r(0) +
2
(1 et )2
22
we get
2
r(t) = fobs (0, t) + 2 (1 et )2 +
2
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f(s)
e(ts) d W
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As the distributional properties of the Hull and White model are similar to
the Vasicek model, pricing European options is straight-forward
The price at time t of a European Call option on an S -bond with maturity
date T and strike price K is
C(t) = P(t, S)(d1 ) K P(t, T )(d2 )
where is the CDF of a standard Normal and
d1 =
p
1
P(t, S)
+
,
log
p
K P(t, T )
2
d2 = d1 p
v
t 1 e2(T t)
p := (1 e(ST ) )
2
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Dothan Model
In 1978, Dothan proposed the model
d r(t) = r(t) dW (t)
where W (t) is a P-BM

The market price of risk is assumed constant, which gives
f(t)
d r(t) = r(t) d t + r(t) d W
f(t) is a Q-BM
under Q where W
Notice that this is a lognormal model like the Black-Scholes model for a
share price
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Dothan Model
The solution to the SDE is

r(t) = r(s) exp

2
f(t) W
f(s)) ,
(t s) + (W
2
st
So the Fs -conditional distribution of r(t) is lognormal

EQ [r(t)|Fs ] = r(s)e(ts)
2
VarQ [r(t)|Fs ] = r 2 (s)e2(ts) e (ts) 1

In lognormal models, r(t) cannot go negative which is desirable
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Dothan Model
No closed-form solution for T -bond prices exists
Recall that the cash-bond is given by
Z t

B(t) = exp
r(u) du
0
Take > 0 small, then
EQ [B()] = EQ exp
Z

r(u) ds
r(0) + r()
EQ exp
2
X
EQ e e , X Normal
=
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Dothan Model
This means that the Dothan model cannot be used to price Eurodollar
futures
This is why Market Models have been introduced
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Black-Karasinski Model
In 1991, Black and Karasinski introduced the following model.
Start with Y (t) = log(r(t)), whereby
f(t)
d Y (t) = (t)(log (t) Y (t)) d t + (t) d W
f(t) is a Q-BM
where W
Applying Its formula gives

(t)2
f(t)
log r(t) d t + (t)r(t) d W
d r(t) = (t)r(t) log (t) +
2(t)
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Black-Karasinski Model
Under this model, r(t) has a local mean-reversion level of
2
(t)
(t) exp
2(t)
Like the Dothan model, there is no closed-form solution for T -bond prices
It is a lognormal model
Similar to the Dothan model, we get
EQ [B()]
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as 0
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The Heath-Jarrow-Morton (HJM) Framework
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The HJM Framework
The HJM approach gives a very general framework that we can work in to
develop a no-arbitrage model
It describes how a general model for the term-structure should evolve in a
way that is arbitrage-free and which the initial forward-rate curve is part of
the input
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The HJM Framework

We start with infinitely many processes f (t, T ) for 0 t < T : one process
for each T R+
We will consider the one-factor version: all f (t, T ) are driven by the same
Brownian motion W (t)
We have that f (t, T ) satisfies
d f (t, T ) = (t, T )d t + (t, T )dW (t)
for any fixed maturity T
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The HJM Framework

Or equivalently,
f (t, T ) = f (0, T ) +
(s, T ) ds +
(s, T ) dW (s)
The coefficients and may depend upon f (t, T ) or the whole forward
curve at time t
Or even more generally, upon F t = ({W (s) : s t})
As all f (t, T ) depend on the same BM, the changes over the whole
forward rate curve are perfectly related to each other (in a nonlinear way)
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The HJM Framework

Technical Conditions
For all T , (t, T ) and (t, T ) are previsible and depend only upon the
history of W (s) up to time t
Z TZ T
|(s, t)| dsd t < for all T
sup k(s, t)k < for all T (for each -path)

s,tT
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The HJM Framework
We have the forward curve dynamics under P given by

Z t
Z t
f (t, T ) = f (0, T ) +
(s, T ) ds +
(s, T ) dW (s)
The key insight of HJM (1980) is: if we assume that the dynamics of f (t, T )
lead to an arbitrage-free model then there must be a drift condition
Our aim is now to determine what this drift condition is
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The HJM Framework
Define the risk-free asset

Define the tradable assets
Change measure from P to EMM Q
Determine the replicating strategy for a claim X
Workout the drift restriction for this all to work
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The Risk-Free Asset

We now need to define the risk-free asset in the HJM framework
The risk-free asset is simply the cash account B(t) which satisfies
dB(t) = r(t)B(t) d t
Recall that it is called risk-free as there is no BM term: there is no price
risk, in the worst case you get back your initial deposit B(0)
Solving the SDE, we get
B(t) = B(0) exp
Z

r(u) du
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The Risk-Free Asset

Since
f (t, T ) = f (0, T ) +
(s, T )ds +
(s, T )dW (s)
we get
r(T ) = lim f (t, T ) = f (0, T ) +
t%T
(s, T ) dW (s) +
(s, T ) ds
r(T ) may or may not be Markov depending on the form of (s, T )
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The Risk-Free Asset

We now plug the HJM formula for r(t) into B(t) to get
B(t) = B(0) exp
Z
0
f (0, u) du +
Z tZ
0
(s, u) duds
Z t Z
0
(s, u)dW (s) du =
(s, u)du dW (s)
Noticed that we changed the order of integration

Z t Z u

Z t Z t
0
(s, u)du dW (s)
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Tradable Assets
Our tradable assets will be all the zero-coupon bonds with prices P(t, T )
for T > t
Our T -bond prices are given by
T
P(t, T ) = exp
f (t, u) du
Plugging in our forward curve f (t, T ) we get

T
Z t Z
P(t, T ) = exp
(s, u) du dW (s)
f (0, u) du
t
Z tZ
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(s, u) duds
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Tradable Assets
Define the discounted asset price
Z(t, T ) :=
P(t, T )
B(t)
Combining integrals and taking B(0) = 1, we get

Z(t) = exp
S(s, T )dW (s)
f (0, u) du
with
S(s, T ) :=
Z tZ
(s, u) duds
(s, u) du
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Tradable Assets
S(s, T ) is interpreted as the volatility of P(t, T )

Note that S(s, T ) is negative which makes sense as bond prices go down
when interest rates go up
What are the dynamics of Z(t, T )?
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Tradable Assets
Using Its formula,
d Z(t, T ) = Z(t, T )
Z T
1 2
(t, u)du d t + S(t, T )dW (t)
S (t, T )
2
t
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Change of Measure
We now want to make the discounted asset price into a martingale

We achieve this by changing measure
The required change of measure drift (market price of risk) for the T -bond
is
Z T
1
1
(t, u) du
(t) = S(t, T )
2
S(t, T ) t
We assume that (t) satisfies the Novikov condition
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Change of Measure
By Girsanovs theorem, there exists a measure Q equivalent to P such that
Z t
f(t) = W (t) +
W
(s) ds
0
is a Q-BM
Under Q we have
f(t)
d Z(t, T ) = Z(t, T )S(t, T )d W
Therefore, Z(t, T ) is a martingale under Q (assuming S(t, T ) satisfies the
technical condition)
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Change of Measure
It follows that the dynamics of the T -bond prices under Q are given by

f(t)
d P(t, T ) = P(t, T ) r(t) d t + S(t, T )d W
So all T -bonds have expected return equal to the risk-free rate r(t) under
Q
We now need to determine the relationship between (t, T ), (t, T ), and
(t) so that the model is arbitrage-free
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Replicating Strategies
Suppose that we have a claim X at time S with S < T on a T -bond

We now determine a hedging strategy for X in terms of the cash holding
with value B(t) and the T -bond with value P(t, T )
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Find the equivalent measure Q under which Z(t, T ) is a martingale
Define the Q-martingale D(t) = EQ [B(S)1 X |F t ]
Find the previsible process (t) such that
Z t
D(t) = D(0) +
(s) d Z(s, T )
Define (t) = D(t) (t)Z(t, T )

The trading strategy ((t), (t)) represents the number of units of B(t)
and P(t, T ) respectively is self-financing, replicating strategy for the claim
X at time S
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We have already found the EMM Q under which Z(t, T ) is a martingale

We define D(t) = EQ [B(S)1 X |F t ]
D(t) is automatically a Q-martingale by the tower property for conditional
expectations
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By the Martingale Representation Theorem, there exists a previsible

process (t) such that
Z t
D(t) = D(0) +
(s) d Z(s, T )
Alternatively written d D(t) = (t)d Z(t, T )
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Suppose we have a trading strategy which holds (t) units of the T -bond
with price P(t, T )
Set (t) = D(t) (t)Z(t, T ) to be the amount of cash B(t) that we hold
at time t
The value of the portfolio at time t is given by
V (t) = B(t)D(t) = B(t)EQ [B(S)1 X |F t ]
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The instantaneous change in the portfolio is

dV (t) = d(B(t)D(t))
= D(t)dB(t) + B(t)d D(t)
= r(t)B(t)D(t)d t + B(t)(t)d Z(t, T )
as d B(t) = r(t)B(t)d t and d D(t) = (t)d Z(t, T )
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We have
d P(t, T ) = d(B(t)Z(t, T )) = r(t)B(t)Z(t, T )d t + B(t)d Z(t, T )
The instantaneous investment gain is
(t)dB(t) + (t)d P(t, T )

= [D(t) (t)Z(t, T )]B(t)r(t)d t
+ (t)[r(t)B(t)Z(t, T )d t + B(t)d Z(t, T )]
= r(t)B(t)D(t)d t + (t)B(t)d Z(t, T )
= d V (t)
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The investment is self-financing as

(t)dB(t) + (t)d P(t, T ) = d V (t)
Therefore, V (t) is the value at time t of the claim X with maturity S
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The Arbitrage-Free Market
Suppose that X = 1 at maturity S then X is an S -bond payoff

We have determined that the arbitrage-free price is then

ZS

r(u) du F t
P(t, S) = B(t)EQ B(S)1 |F t = EQ exp
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The discounted S -bond is

Z(t, S) =

P(t, S)
= EQ B(S)1 |F t
B(t)
so that Z(t, S) is a Q-martingale

This must be true for any maturity S that we choose
This implies that all bonds must be turned into Q-martingales by the same
change of measure: they all have the same market price of risk (t)
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Thus for all maturities T ,
1
1
S(t, T )
2
S(t, T )
(t, u) du = (t)
t
Or equivalently,
Z
t
1
(t, u) du = S(t, T )2 (t)S(t, T )
2
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Recall that
S(t, T ) =
(s, u) du
so that
And differentiating
S(t, T ) = (t, T )
T
RT
t
(t, u) du with respect to T we get
(t, T ) = (t, T ) [(t) S(t, T )]
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Now recall that our original model for the forward dynamics under P was
d f (t, T ) = (t, T )d t + (t, T )dW (t)
Substituting in our arbitrage-free drift (t, T ) and changing to Q gives

f(t) (t)d t
d f (t, T ) = (t, T )d t + (t, T ) W
f(t) (t, T )(t)d t
= (t, T )[(t) S(t, T )]d t + (t, T )d W
f(t)
= (t, T )S(t, T )d t + (t, T )d W
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Therefore, under Q we have
f(t)
d f (t, T ) = (t, T )S(t, T )d t + (t, T )d W
Notice that the dynamics are solely determined from the volatility (t, T )
Consequently,
r(t) = f (0, t)
(s, T )S(s, t) ds +
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f(s)
(s, t)d W
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Week 10
Multifactor Models
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Multifactor Models
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Introduction
We shall now look at models which include more than one source of
randomness
When you look at historical interest rate data to see that changes in
interest rates with different maturities are not perfectly correlated as
predicted by one-factor model
We can look at some data from
http://www.rba.gov.au/statistics/tables/
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Yield (%)
5
6
Cash Yield Vs. Bond Yield
2000
2005
Year
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2010
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Long Yield (%)

5
6
Cash Yield Vs. Bond Yield
5
6
Short Yield (%)
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Introduction
Data analysis shows that multi-factor models may be more appropriate

Clearly, a one-factor time-homogeneous model is inappropriate
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Introduction
One of the main reasons is to deal with more-complex interest rate

options which refer to two or more stochastic underlying quantities
For example, consider the option with the following payoff at time T :
X = max [R(T, T + 5) R(T, T + 10), 0]
A one-factor model would probably overprice this contract due to the
perfect (non-linear) correlation between the rates in such a model
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Multi-factor Affine Models
We have already seen one-factor affine models: Vasicek (1977),

Cox-Ingersoll-Ross (1985), Ho-Lee (1986), and Hull-White (1990)
We now look at multi-factor models which have the affine form
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Consider an n-dimensional diffusion model
X 1 (t)
X 2 (t)
X (t) =
...
X n (t)
The model is called affine if the T -bond prices are of the form
n
X
P(t, T ) = exp A(t, T ) +
B j (t, T )X j (t)
j=1
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Or written in vector notation as

P(t, T ) = exp A(t, T ) + B(t, T ) T X (t)
where
B1 (t, T )
B2 (t, T )
B(t, T ) =
..
Bn (t, T )
B(t, T ) T is the transpose of B(t, T )
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The model is time homogeneous if X is time homogeneous and A(t, T )

and B(t, T ) are functions of T t only
We shall now restrict ourselves to the time homogeneous models for
simplicity and use A(T t) and B(T t)
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Recall that for one-dimensional affine models of the short-rate r(t) we

must have
f(t)
d r(t) = (a + br(t))d t + r(t) + d W
Q: What form must the SDE of X (t) have in the n-dimensional case if X (t)
is affine?
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Theorem (Duffie and Kan 1996)
Suppose P(t, t + ) = exp[A() + B() T X (t)]. Then X (t) has the SDE
f(t),
d X (t) = ( + BX (t))d t + S D(X (t))d W
where = (1 , . . . , n ) T is a constant vector, B = (bi j ) and S = (i j ) are a

constant matrices and D(X (t)) is the diagonal matrix
q
1T X (t) + 1
0

0
0
2T X (t) + 2 0
0
..
.
.
..
..
D(X (t)) =
..
..
...
.
.
0
nT X (t) + n
where each i R and each i = (i1 , , in ) T is a constant vector.
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Within this framework, we need to ensure that each of the volatility

processes
iT X (t) + i ,
for i = 1, . . . , n remain positive (preferably strictly positive)

Duffie and Kan (1996) provide conditions on the parameters for the
volatility processes to remain positive
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Consider the spot rates in this framework
R(t, t + j ) =
1
[A( j ) + B() T X (t)]
j
for j = 1, . . . , n for terms to maturity 1 < 2 < < n

In vector notation, R(t) = (R(t, t + 1 ), . . . , R(t, t + n )) T , giving
R(t) = aR + BR X (t)
for a constant vector aR Rn and constant matrix BR Rnn
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If the matrix BR is invertible (i.e., exists BR1 such that BR1 BR = I ) then
X (t) = BR1 (R(t) aR )
Hence,

P(t, t + ) = exp A() + B() T BR1 (R(t) aR )

()R(t)
= exp A()
+B
for suitable functions A()

and B ()
Therefore, it the model is affine in X (t) then it can be reformulated in a
way which is affine in R(t)
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These transformations make the n-factor model simple to calibrate if we

are given at time t the market spot rates
R(t, t + 1 ), . . . , R(t, t + n )
Choosing a specific model gives A()

and B () then the bond prices are

()R(t)
P(t, t + ) = exp A()
+B
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Models that are time-homogeneous under Q do not need to be time
homogeneous under the real-world measure P
Assume that the vector of market prices of risk
(t) = (1 (t), . . . , n (t)) T
is previsible and satisfies the Novikov condition

f(t) be a n-dimensional Q-BM. Then
Let W
Z t
f(t) +
W (t) := W
(s) ds
0
is a (n-dimensional) P-BM
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The SDE for X (t) under P then becomes
d X (t) = [ + BX (t)]d t + SD(X (t))[dW (t) + (t)d t]

= [ + BX (t) + SD(X (t))(t)]d t + S D(X (t))dW (t)
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We shall now consider three special cases in the affine framework:

Gaussian multi-factor models
Generalized CIR models
The Longstaff and Schwartz model (1992)
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Gaussian Multi-factor Models
Gaussian models allow interest rates to become negative

The first multifactor extension of the Vasicek (1977) model was developed
by Langetieg (1980)
Later works include Beaglehole-Tenney (1991) for the general theory and
Babbs-Nowman (1999) for model calibration
We shall now consider the theory of time-homogeneous Gaussian models
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Let X (t) be an n-dimensional diffusion process with SDE
f(t)
dX (t) = BX (t)d t + K W
f(t) is a
where B and K are real-valued constant n n matrices and W
n-dimensional Q-BM
The risk-free rate of interest is
r(t) = + T X (t)
where = (1 , . . . , n ) T Rn
If all i 6= 0 we can scale X (t) and assume i = 1
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The matrix B has a spectral decomposition B = BR B L

= diag(1 , . . . , n ) is the diagonal matrix of eigenvalues of B (some
these eigenvalues may be complex)
B L and BR are the matrices of left and right eigenvectors of B . Column i of
BR is the right eigenvector of B corresponding to i
The columns of BR are scaled in a way which ensures BR B L = I
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This decomposition is not unique

For X (t) to be stationary we require that the real parts of all eigenvalues
1 , . . . , n are negative
We have B k = BR k B L which is useful for defining the exponential of a
matrix
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Recall that e x = 1 + x +
x2
2!
x3
3!
+ . . . so we have
exp(B) = BR exp()B L
where, after defining 0 = I ,
exp() = I + +
=
2 3
+
+ ...
2!
3!
X
k
k=0
k!
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Define
Y (t) := et B L X (t)
Applying the n-dimensional Its formula,

f(t)
dY (t) = et B L K d W
Hence, we have
Y (t) = Y (0) +
f(u)
eu B L K d W
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But as Y (t) = et X (t) and BR B L = I we have
X (t) = BR e t Y (t)
Using the fact that BR e t B L = e t B , it follows that
Z t
f(u)
e(tu)B K d W
X (t) = e t B X (0) +
This is an n-dimensional Orstein-Uhlenbeck process (i.e., solution to

n-dim Vasicek model that mean-reverts to zero)
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The requirement that the real parts of the eigenvalues 1 , . . . , n are
negative ensures that
exp(t) 0
and
exp(t B) 0
as t
Think of the 1-dimensional case where a R, then
et a 0
as
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Now let
R(T ) =
r(t) d t
0
= T +
T X (t) d t
This is Normally distributed with
EQ [R(T )] = T + T BR 1 (e T I)B L X (0)

Z T
T BR 1 (e T I)B L K K T B LT (e T I)1 BRT d t
VarQ [R(T )] =
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Example
Simplest 2-dimensional case is
1 0
B = BR B L
B=
0 1
then
BR = B L = I, = I
EQ [R(T )] = T + T 1 (e T I)X (0)

= T T 1 (I e t )X (0)
and compare to the solution to the 1-dimensional Vasicek model
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We then have that T -bond prices at t = 0 are given by
Z t

P(0, T ) = EQ
r(t) d t F0
0
= EQ [ex p(R(T ))|X (0)]

= exp EQ [R(T )|X (0)] +

1
VarQ [R(T )|X (0)]
2
Recall identifying Normals: If Z N (, 2 ) then
Z
1 2 2
E e
= exp +
2
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Example
(Beaglehole and Tenney 1991) We take
r(t) = (X 1 (t) + 1 ) + (X 2 (t) + 2 )
{z
}
|
{z
} |
inst. price inflation
where
inst. real interest
f1 (t),
d X 1 (t) = 1 X 2 (t)d t + 11 d W
f1 (t) + 22 d W
f2 (t).
d X 2 (t) = 2 X 1 (t)d t + 21 d W
Q: What are the matrices B and K ?
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Example
We take
r(t) = + X 1 (t),
where
f1 (t),
d X 1 (t) = 1 (X 2 (t) X 1 (t))d t + 11 d W
f1 (t) + 22 d W
f2 (t).
d X 2 (t) = 2 X 2 (t)d t + 21 d W
In this model, + X 2 (t) behaves like a stochastic (local) mean reversion level
for r(t).
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Generalized CIR Models

A number of multi-factor CIR models have been proposed
In terms of the general framework
f(t),
dX (t) = ( + BX (t))d t + S D(X (t))d W
q
where D(X (t)) = diag( 1T X (t), . . . , nT X (t)) and

P(t, t + ) = exp[A() + B() T X (t)]
The risk-free rate of interest is then defined as
r(t) =
n
X
X i (t)
i=1
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As D(X (t)) is diagonal, the X i (t) are independent
We get that

r(u) du F t
n
X
P(t, T ) = EQ exp
= EQ exp
n
Y
EQ exp
t
i=1
= exp
i=1
T
n
X

X i (u) du F t

X i (u) du F t
Ai (T t)
i=1
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n
X
Bi (T t)X i (t)
i=1
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P(t, T ) is the product of n one-dimensional CIR
The coefficients are
Ai () =
Bi () =
2i i
2i
2i e(i +i )/2
log
(i + i )(ei 1) + 2i

2(ei 1)
,
(i + i )(ei 1) + 2i
2i + 22i
If we have 2i i > 2i then the probability that X i (t) hits zero is zero
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The Longstaff and Schwartz Model

A variation of the two-factor CIR model was proposed by Longstaff and
Schwartz in 1992
Take for i = 1, 2 the SDEs
dYi (t) = i (i Yi (t)) d t +
fi (t)
Yi (t)d W
f1 and W
f2 are independent Q-Brownian motions
where W
For constants c1 and c2 , define
r(t) := c1 Y1 (t) + c2 Y2 (t),
V (t) := c12 Y1 (t) + c22 Y2 (t)
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d r(t) = c1 d Y1 (t) + c2 Y2 (t)
f1 (t)
= c1 1 (1 Y1 (t))d t + Y1 (t)d W
f2 (t)
+ c2 2 (2 Y2 (t))d t + Y2 (t)d W
(c2 1 c1 2 )r(t) + (2 1 )V (t)

= c1 1 1 + c2 2 2
dt
c2 c1
v
v
u
u
t c1 (c2 r(t) V (t))
t c2 (V (t) c1 r(t))
f1 (t) +
f2 (t)
+
dW
dW
c2 c1
c2 c1
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It can be shown that instantaneous variance of r(t) is V (t)d t which is the

reason why the model was formulated this way
Also, by using r(t) and V (t) we focus on the variables that are believed to
influence the pricing of derivatives, instead of using Y1 (t) and Y2 (t)
r(t) is the level and V (t) is the volatility
If c1 < c2 then the form of r(t) and V (t) means that V (t) is limited to the
region (c1 r(t), c2 (t))
The model has richer dynamics when c1 and c2 are far apart
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Multifactor Heath-Jarrow-Morton Models

We can easily extend the one-factor HJM framework to the multi-factor
setting
We assume the existence of a given model under the risk-neutral measure
Q
We model the T -bond dynamics
f(t)]
d P(t, T ) = P(t, T )[r(t) d t + S(t, T ) T d W
where the volatility function S(t, T ) = (S1 (t, T ), . . . , Sn (t, T )) T is

f(t) is a standard n-dim BM under Q
previsible and W
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The forward dynamics are given by

f(t)
d f (t, T ) = (t, T ) T S(t, T )d t + (t, T ) T d W
where
(t, T ) = (1 (t, T ), . . . , n (t, T )) T
i (t, T ) =
Si (t, T )
T
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Example
(Rebonato 1996)
Suppose that primary sources of randomness in forward-rate curve are:
slope of curve and twist in curve
In a Gaussian setting, this can be modelled by
1 (t, T ) = 11 e1 (T t)
2 (t, T ) = 21 e1 (T t) + 22 e2 (T t)
Example: 0 < 2 < 1 then can we achieve a twist by adding the
constraints 22 > 0 and 21 < 22
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Week 11
The Forward-Measure Approach
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In pricing problems that we have seen so far we have expressed prices in

terms of expectations under the risk-neutral equivalent martingale
measures Q
Sometimes the calculation can be made easier by making a second
change of measure from Q to the forward measure
In recent years, this idea has been critical in the development of totally
new approaches to interest rate modelling
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A New Numeraire
For a T -bond, we have the dynamics
f(t)]
d P(t, T ) = P(t, T )[r(t) d t + S(t, T )d W
f(t) is a Q-BM
where W
Previously, we considered the discounted price process
Z(t, U) =
where B(t) = exp
R t
0
P(t, U)
B(t)
r(s) ds is the cash account at time t
The discounted price was a martingale under the same measure Q for all
maturity dates U
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A New Numeraire
Lets change the numeraire from B(t) to P(t, T ). Thus we consider
Y (t, U) =
P(t, U)
P(t, T )
Then we get
1
1
1
d Y (t, U) =
d P(t, U)+P(t, U)d
+d P(t, U)d
P(t, T )
P(t, T )
P(t, T )
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A New Numeraire
Then
f(t)
d Y (t, U) = Y (t, U) (S(t, U) S(t, T )) d W
+ Y (t, U)S 2 (t, T ) d t Y (t, U)S(t, U)S(t, T ) d t
c(t) with
Now suppose we define a new process W
c(0) = 0
W
and
c(t) = d W
f(t) S(t, T ) d t
dW
Then
c(t) + S(t, T )d t]
d Y (t, U) = Y (t, U) (S(t, U) S(t, T )) [d W
Y (t, U)S(t, T )[S(t, U) S(t, T )]d t
c(t)
= Y (t, U)[S(t, U) S(t, T )]d W
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A New Numeraire
So we have
c(t)
dY (t, U) = Y (t, U)[S(t, U) S(t, T )]d W
It appears that we can find a suitable measure under which Y (t, U) for all
U > T are martingales
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Change of Measure
Define (t) = S(t, T )
By Girsanovs theorem, there exists a measure P T which is equivalent to Q
such that
Z
t
c(t) = W
f(t) +
W
(s) ds
is a Brownian motion under P T

Under the assumption that Novikovs condition holds:
ZU
1
EQ exp(
(t)2 d t) <
2
0
P T is called a forward measure
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Change of Measure
The forward measure depends on the forward maturity date T but not
upon the maturity date U of the bond under consideration
The Y (t, U) for U > T are all martingales under the measure P T
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Derivative Payments
Let X be a claim contingent upon F T payable at time T
Define
D(t) = EPT

X
F t = EPT [X |F t ]
P(T, T )
D(t) is martingale under P T

Y (t, U) is also a martingale under P T
By MRT, there exists a previsible process (t) such that
d D(t) = (t)d Y (t, U)
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A Replicating Strategy
Let (t) = D(t) (t)Y (t, U)
Consider the investment strategy which holds at time t , (t) units of the
numeraire P(t, T ) and (t) units of U -bond
The value of this portfolio at time t is
V (t) = P(t, T )D(t)
Now
f(t)]
c(t) + S(t, T )d t)]
= P(t, T )[r(t)d t + S(t, T )(d W
c(t))
= P(t, T )([r(t) + S 2 (t, T )]d t + S(t, T )d W
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And we have
d D(t) = (t)dY (t, U)

c(t)
= (t)Y (t, U)(S(t, U) S(t, T ))d W
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Thus
d V (t) = D(t)d P(t, T ) + P(t, T )d D(t) + d P(t, T )d D(t)
c(t))
= P(t, T )D(t)((r(t) + S 2 (t, T ))d t + S(t, T )d W
c(t)
+ (t)P(t, T )Y (t, U)(S(t, U) S(t, T ))d W
c(t)]
+ (t)P(t, T )Y (t, U)[(r(t) + S 2 (t, T ))d t + S(t, T )d W
c(t)]
[(S(t, U) S(t, T ))d W
c(t)]
= V (t)[(r(t) + S 2 (t, T ))d t + S(t, T )d W
c(t)
+ (t)P(t, U)(S(t, U) S(t, T ))d W
+ (t)P(t, U)S(t, T )(S(t, U) S(t, T )) d t
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The instantaneous investment gain is thus
(t)d P(t, T ) + (t)d P(t, U)
c(t))
= (D(t) (t)Y (t, U))P(t, T )((r(t) + S 2 (t, T ))d t + S(t, T )d W
c(t) + S(t, T )d t))
+ (t)P(t, U)(r(t)d t + S(t, U)(d W
= d V (t)
Hence ((t), (t)) is a self-financing strategy
V (T ) = X so it is also a replicating strategy
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Theorem
The price at time t for the claim X payable at time T is
V (t) = P(t, T )EPT [X |F t ]
This price is independent of the choice of the hedging asset P(t, U)
But the hedging strategy depends upon the choice of U
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Evaluation of a Derivative Price
Suppose that the claim X at T is a function of P(T, U)

Under the martingale measure Q we have
Z T
V (t) = EQ exp

r(s) ds X F t
Evaluation of this expectation requires the knowledge of the joint

RT
distribution of P(T, U) and exp( t r(s) ds) under Q
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On the other hand, under the forward measure approach

V (t) = P(t, T )EPT [X |F t ]
We only need to establish the distribution of X under P T
This is a lot easier to calculate
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Lemma
The forward price at time t for delivery of P(T, U) at time T is given by
EPT [P(T, U)|F t ].
Proof: Since Y (t, U) is a martingale under P T we have

EPT [Y (T, U)|F t ] = Y (t, U).
Therefore,
EPT

P(T, U)
P(t, U)
,
F t = EPT [P(T, U)|F t ] =
P(T, T )
P(t, T )
which is the forward price.
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Lemma
Suppose that the T -bond volatility S(v, V ) is deterministic. Then under P T ,
P(t, U) is lognormal with
Z T
(S(v, U) S(v, T ))2 d v
VarPT [log P(T, U)|F t ] = b2 =
and
EPT [log P(T, U)|F t ] = a = log
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P(t, U) 1 2
b
P(t, T ) 2
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Vasicek Model
Example
Under the Vasicek model,
S(v, U) =
(1 e(Uv) )
Which gives
2
2
b = 2
(e(T v) e(Uv) )2 d v
t
(1 e(UT ) )2 (1 e2(T t) )
3
2
2
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Lemma
Suppose that a random variable Y has a lognormal distribution with
parameters a and b2 ; that is, log Y N (a, b2 ). Then for any constant K > 0:
E[(Y K)+ ] = E[Y ](h) K(h b),
where
log(E[Y ]/K) + 12 b2
a + b2 log K
h=
=
b
b
and is the CDF of a standard Normal distribution.
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We can apply this lemma to price a call option with maturity T and strike
price K on a U -bond with price P(t, U)
We get
EPT [(P(T, U) K)+ |F t ] = EPT [P(T, U)|F t ](h) K(h b)
where
1 2
1
P(t, U)
log K + b
h=
log
b
P(t, T )
2
1
P(t, U)
1
= log
+ b
b
K P(t, T ) 2
Recall
b =
(S(v, U) S(v, T ))2 d v

t
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Hence, the price at time t of the call option is

V (t) = P(t, U)EPT [(P(T, U) K)+ |F t ]
= P(t, U)(h) K P(t, T )(h b)
Notice the similarity to the Black-Scholes formula
This formula only holds when bond prices are lognormally distributed
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Equity Options with Stochastic Interest

The forward measure approach can also be used to price equity options
when the cash rate r(t) is stochastic
Suppose we have the usual model
f1 (t)]
f(t) is a BM under the martingale measure Q
where W
Consider an equity index R(t) which includes full reinvestment of
dividends
Under Q suppose that R(t) has the SDE
f1 (t) + 2 d W
f2 (t)]
dR(t) = R(t)[r(t)d t + 1 d W
f2 (t) is second BM under Q independent of W
f1 (t)
where W
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Let D(t) = EPT [ f (R(T ))|F t ]. This is a martingale under P T
The processes
b (t, U) =
P
P(t, U)
,
P(t, T )
b(t) =
R
R(t)
P(t, T )
are both martingales under P T

By the multidimensional MRT, there exist previsible processes P (t) and
R (t) such that
b (t, U) + R (t)d R
b(t)
d D(t) = P (t)d P
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Define
b (t, U) R (t)R
b(t)
(t) = D(t) P (t) P
Consider the portfolio process which holds at time t

P (t)
of P(t, U)
R (t) of R(t)
(t) of P(t, T )
The value at time t is

V (t) = P(t, T )D(t) = P(t, T )EPT [ f (R(T ))|F t ]
This portfolio is self-financing and replicating ( t = T ) and V (t) is the
unique no-arbitrage price at time t
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Theorem
Consider the European call option f (R(T )) = (R(T ) K)+ . The price for this
option at time t is
V (t) = P(t, T )[F (t)(h) K(h b)]
where
h=
b2 =
log(F (t)/K) + 21 b2
b
T
(1 S(v, T ))2 d v + 22 (T t)
t
F (t) =
R(t)
P(t, T )
[forward price for R(T )]
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Week 12
Market Models
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Market Models
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Introduction
Instantaneous forward rates are an unobservable quantity

This makes the forward curve T 7 f (t, T ) difficult to estimate
This lead to the suggestion that maybe one should develop a model of
directly observable (i.e., market quoted) quantities such as LIBOR
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Introduction
A key modelling assumption was that relevant market rates are lognormal
This was an assumption already used by traders to price some interest
rate derivatives
The market practice was/is to use Blacks formula
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Blacks Formula
Definition
A caplet with reset date T and settlement date T + pays the holder the
difference between a simple market rate F (T, T + ) and the strike rate
Its cash flow at time T + is
(F (T, T + ) )+
We write Cpl(t; T, T + ) for the price at time t of the caplet with reset
date T and settlement date T +
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Blacks Formula
Definition
A Cap is a strip of caplets. It consists of:
A number of future dates T0 < T1 < < Tn with Ti Ti1 =
A cap rate
We write Cp(t) for its price at time t
We have
Cp(t) =
n
X
Cpl(t; Ti1 , Ti )
i=1
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Blacks Formula
It is market practice to price a cap/floor according to Blacks formula
Let t T0 . Blacks formula for the value of the i th caplet is
Cpl(t; Ti1 , Ti ) = P(t, Ti )[F (t; Ti1 , Ti )(d1 (i; t)) (d2 (i; t))]
where
d1,2 (i; t) =
log
F (t;Ti1 ,Ti )
12 (t)2 (Ti1 t)
p
(t) Ti1 t
Here (t) is the cap implied volatility (it is the same for all caplets
belonging to a cap)
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Blacks Formula
Typically, t = 0, T0 = and = 3 months (US) or = 6 months (Europe)

Caps are quoted in the market in terms of their implied volatilities
So to price a Cap, one takes the implied volatility (t) quoted at time t
and plugs it into the Black model
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Blacks Formula
ATM vols (in %)

13 14 15 16 17 18 19
ATM Cap Volatilities
0
10
15
20
Maturity (in years)
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25
30
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Blacks Formula
This approach is completely heuristic!

It is based on the assumption that the simple market rates F (t; Ti1 , Ti )
are lognormal
It is a challenge for any market realistic interest rate model to match the
given volatility curve observed in the market
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Market Models
We are now going to look at the development of Market Models which

attempt to construct a model of observable interest rates such as LIBOR
Sometimes denoted LMM (in job ads): LIBOR Market Model
The first developments all happened very quickly in 1997
Miltersen, Sandmann & Sondermann (1997): formulae for zero-coupon
bond options, caps and floors
Further improvements were obtained by Brace, Gatarek, and Musiela
(1997), Jamshidian (1997), and Musiela and Rutkowski (1997)
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LIBOR
There are two types of market interest rates: LIBOR and forward LIBOR
LIBOR is an annualized, simple rate of interest that will be delivered at the
end of a defined period
The -LIBOR denoted by F (T, T + ) means that an investment of 1 at
time T will grow to 1 + F (T, T + ) at time T +
LIBOR is always quoted as an annual rate of interest even though it
typically applies over shorter periods
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LIBOR
For a fixed > 0, the forward -period LIBOR for the future date T
prevailing at time t is the simple forward rate
1
P(t, T )
L(t, T ) := F (t; T, T + ) =
1
P(t, T + )
With this notation, L(T, T ) = F (T ; T, T + ) is the LIBOR rate
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LMM: Heuristic Derivation
Let P T + be the (T + ) forward measure

Recall that
P(t, T )
P(t, T + )
is a martingale under P T +
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We also know that
P(t, T )
P(t, T )
d
=
T,T + (t)dW T + (t)
P(t, T + )
P(t, T + )
R T +
where T,T + (t) = T (t, u) du
Using this with the definition of L(t, T ) gives
1 P(t, T )
1
P(t, T )
d L(t, T ) = d
=
T,T + (t)dW T + (t)
P(t, T + )
P(t, T + )
1
= (L(t, T ) + 1) T,T + (t)dW T + (t)
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We have
d L(t, T ) =
1
(L(t, T ) + 1) T,T + (t)dW T + (t)
Assumption: there exists a Rn -valued deterministic function (t, T ) such

that
L(t, T )
(t, T )
T,T + (t) =
L(t, T ) + 1
Plugging this in to the above formula, we get
d L(t, T ) = L(t, T )(t, T )dW T + (t)
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The solution of that SDE is given by
Z t
L(t, T ) = L(s, T ) exp
(u, T )dW
T +
1
(u)
2
t
2
k(u, T )k du
So the P T + distribution of log L(t, T ) conditional on F t is Gaussian with

mean
Z T
1
log L(t, T )
k(s, T )k2 ds
2 t
and variance
k(s, T )k2 ds
t
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The time t price of a caplet with reset date T , settlement date T + and
strike rate is thus
i
h R T +

EQ e t r(s)ds (L(T, T ) )+ F t
= P(t, T + )EPT + [(L(T, T ) )+ |F t ]
= P(t, T + )(L(t, T )(d1 (t, T )) (d2 (t, T )))
where
d1,2 (t, T ) :=
log
L(t,T )
21
RT
k(s, T )k2 ds
R T
1/2
2 ds
k(s,
T
)k
t
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This is just Blacks formula for the caplet price with
v
Z T
u
t 1
k(s, T )k2 ds
(t) =
Tt t
This means that any HJM model satisfying
T,T + (t) =
L(t, T )
(t, T )
L(t, T ) + 1
for some deterministic (t, T ) yields Blacks formula for caplet prices
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The question is: Does such a HJM model exist?

The answer is yes, but the construction and proof are not easy
This is carried out in the paper by Brace, Gatarek and Musiela (1997)
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LMM: Direct Approach
We can also construct the LMM using a direct approach

We dont use the HJM framework (although it can be implicitly implied)
We work with the forward measure concept
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Fix a time horizon TM = M with M N

Fix our probability space (, F , (F t ) tTM , P TM )
Under P TM we have a d -dimensional Brownian motion W TM
PTM is the TM -forward measure
Define the dates Tm := m for m = 0, 1, . . . , M
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We now construct a model of M forward LIBOR rates with maturities

T0 , T1 , . . . , TM 1
For every m M 1, we define (t, Tm ) as the volatility of L(t, Tm )
We assume there is an initial positive and nonincreasing term structure of
M bond prices
P(0, T0 ), . . . , P(0, TM 1 )
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Definition
For notational convenience, if S in an It process and H is a predictable
process we write
Z
H S =
H(u)dS(u)
Examples: Recall the stochastic exponential of an It process X is given by

E t (X ) := exp(X 12 X t ) then
Z t
((, T ) W T ) t =
(u, T )dW T (u)
E t ((, T ) W ) = exp
T
Z
0
1
(u, T )dW (u)
2
T
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t
2
|(u, T )| du
0
545 / 561

First, lets postulate the dynamics of L(t, TM 1 ) = F (t; TM 1 , TM ) as
d L(t, TM 1 ) = L(t, TM 1 )(t, TM 1 )dW TM (t),
t [0, TM 1 ]
with initial condition

1
L(0, TM 1 ) =
P(0, TM 1 )
1
P(0, TM )
The solution is
L(t, TM 1 ) = L(0, TM 1 )E t ((, TM 1 ) W TM )
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Or plugging in the definition of L(0, TM 1 ) we get
1 P(0, TM 1 )
1 E t ((, TM 1 ) W TM )
L(t, TM 1 ) =
P(0, TM )
Now we assume that
TM 1 ,TM (t) =
L(t, TM 1 )
(t, TM 1 ),
L(t, TM 1 ) + 1
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t [0, TM 1 ]
547 / 561

Recall that we changed from Q to the forward measure P T and obtained
Z T
T
f(t) (t, T ) d t, (t, T ) :=
dW (t) = d W
(t, u) du
t
in the HJM setup
d f (t, T ) = (t, T )d t + (t, T )dW (t),
Z T
under P
f(t) under Q
(t, u)du d t + (t, T )d W
d f (t, T ) = (t, T )
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Change from Q to P TM gives new P TM Brownian motion
f(t) (t, TM )d t
dW TM (t) = d W
Change from Q to P TM 1 gives new P TM 1 Brownian motion
f(t) (t, TM 1 )d t
dW TM 1 (t) = d W
Equate both expression to get transformation from P TM to P TM 1 :
dW TM 1 (t) = dW TM (t) ((t, TM 1 ) (t, TM ))d t

= dW TM (t) TM 1 ,TM (t)d t
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Again, we postulate
d L(t, TM 2 ) = L(t, TM 2 )(t, TM 2 )dW TM 1 (t)
1 P(0, TM 2 )
1
L(0, TM 2 ) =
P(0, TM 1 )
Define
TM 2 ,TM 1 (t) =
L(t, TM 2 )
(t, TM 2 )
L(t, TM 2 ) + 1
And so forth... to obtain a family of M processes
L(t, T0 ), . . . , L(t, TM 1 ),
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t [0, TM ]
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LIBOR Dynamics Under Different Measures

Lemma
Let 0 m, n M 1. Then the dynamics of L(t, Tm ) under P Tn+1 is for m < n
given by
n
X
d L(t, Tm ) = L(t, Tm ) (t, Tm )
Tr ,Tr+1 (t) T d t + (t, Tm )dW Tn+1
r=m+1
For m = n,
d L(t, Tm ) = L(t, Tm )(t, Tm )dW Tn+1 (t)
and for m > n we have
d L(t, Tm ) = L(t, Tm ) (t, Tm )
m
X
Tr ,Tr+1 (t) T d t + (t, Tm )dW Tn+1
r=n+1
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Bond Price Dynamics
We have constructed a market model for LIBOR rates

However, to price bonds and options we need to determine the bond price
dynamics
So now well determine the bond price dynamics and then derive a caplet
pricing formula
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Bond Price Dynamics

For m = 1, . . . , M we can define the forward price process
P(t, Tm1 )
= L(t, Tm1 ) + 1,
P(t, Tm )
Since
t [0, Tm1 ]
P(t, Tm1 )
d
= d L(t, Tm1 )
P(t, Tm )
= L(t, Tm1 )(t, Tm1 )dW Tm (t)
P(t, Tm1 )
Tm1 ,Tm (t)dW Tm (t)
=
P(t, Tm )
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Bond Price Dynamics
Therefore, we get that

P(t, Tm1 )
P(0, Tm1 )
=
E t Tm1 ,Tm W Tm ,
P(t, Tm )
P(0, Tm )
t [0, Tm1 ]
which is a P Tm martingale
This is sometimes call the Tm -forward price process of the Tm1 -bond
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Bond Price Dynamics

We can extend this concept and define the Tm -forward price processes for
all Tk -bonds
When k < m we define
m1
P(t, Tk ) Y P(t, Tr )
=
P(t, Tm ) r=k P(t, Tr+1 )
=
P(t, Tm1 )
P(t, Tk )
P(t, Tk+1 )
P(t, Tm )
For k > m, we define
P(t, Tk )
=
P(t, Tm )
P(t, Tm )
P(t, Tm+1 )
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P(t, Tk1 )
P(t, Tk )
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Bond Price Dynamics

Lemma
For every 1 k 6= m M , the forward price process satisfies

P(t, Tk )
P(0, Tk )
=
E t Tk ,Tm W Tm ,
P(t, Tm )
P(0, Tm )
for the Rd -valued bounded progressive process

Pm1
r=k Tr ,Tr+1 ,
P
Tk ,Tm =
k1
r=m Tr ,Tr+1 ,
Hence,
P(t,Tk )
P(t,Tm )
t [0, Tk Tm ]
k<m
k>m
for t [0, Tk Tm ] is a positive P Tm -martingale.
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Bond Price Dynamics
We can now derive the nominal Tn -bond prices

n
Y
P(Tm , Tk )
1
=
P(Tm , Tn ) =
P(Tm , Tk1 ) k=m+1 L(Tm , Tk1 ) + 1
k=m+1
n
Y
at dates t = Tm
We have derived an arbitrage-free market model for the bonds with
maturities T0 , . . . , TM since we have shown that P Tm is a martingale
measure for the Tm -bond as numeraire
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LMM: Pricing Claims
Any Tm -contingent claim X with EPTm [|X |] < can now be priced at time
t Tm in terms of the Tm -bond numeraire via
V (t) = P(t, Tm )EPTm [X |F t ]
We can also express this price relative to any future Tn -bond
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LMM: Pricing Claims
Lemma
The Tm -bond discounted Tm -claim price satisfies

P(t, Tn )
V (t)
X

=
EPTn
F t
P(t, Tm )
P(t, Tm )
P(Tm , Tn )
for all m < n M .
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LMM: Pricing Claims

Corollary
Let m + 1 < n M . The time Tm price of the nth caplet with reset date Tn1 ,
settlement date Tn and strike rate is
Cpl(Tm ;Tn1 ,Tn ) = P(Tm , Tn )[L(Tm , Tn1 )(d1 (n; Tm )) (d2 (n; Tm ))]
where
d1,2 (n; Tm ) =
log
L(Tm ,Tn1 )
rR
Tn1
Tm
12
R Tn1
Tm
k(s, Tn1 )k2 ds
k(s, Tn1 )k2 ds
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LMM: Pricing Claims
This is Blacks formula for the caplet price with

Z Tn1
1
2
(Tm ) =
k(s, Tn1 )k2 ds
Tn1 Tm T
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Advanced Derivatives Pricing and Applications

Dale Roberts (c) 2011-2014

Last Modified: 14/10/2014 08:19

Vectors and Matrices

Dale Roberts (c) 2011-2014

Last Modified: 14/10/2014 08:19

Dale Roberts (c) 2011-2014

Vectors and Matrices

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Dale Roberts (c) 2011-2014

Last Modified: 14/10/2014 08:19

The norm of a vector x is given by

Dale Roberts (c) 2011-2014

Last Modified: 14/10/2014 08:19

a11 a12 a1n

Dale Roberts (c) 2011-2014

Last Modified: 14/10/2014 08:19

wherein all entries not on the main diagonal are zero.

Dale Roberts (c) 2011-2014

ai j x j = ai1 x 1 + ai2 x 2 + + ain x n

If A = [1 2 n ] is a single row (i.e., m = 1), then (1) becomes

Dale Roberts (c) 2011-2014

Last Modified: 14/10/2014 08:19

If the i th row of A is denoted by

Dale Roberts (c) 2011-2014

Last Modified: 14/10/2014 08:19

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Dale Roberts (c) 2011-2014

Last Modified: 14/10/2014 08:19

The determinant of n n matrix A is denoted by det A = |A|.

Dale Roberts (c) 2011-2014

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Dale Roberts (c) 2011-2014

aik Cik (Expansion along i th row)

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Dale Roberts (c) 2011-2014

Last Modified: 14/10/2014 08:19

Inverses of Square Matrices

You can verify that AA1 = I and A1 A = I .

Dale Roberts (c) 2011-2014

Last Modified: 14/10/2014 08:19

Dale Roberts (c) 2011-2014

Functions of Bounded Variation

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If f1 and f2 are nondecreasing functions on a closed interval [a, b] then

Dale Roberts (c) 2011-2014

Last Modified: 14/10/2014 08:19

Dale Roberts (c) 2011-2014

Last Modified: 14/10/2014 08:19

Dale Roberts (c) 2011-2014

Last Modified: 14/10/2014 08:19

Functions of Bounded Variation

Dale Roberts (c) 2011-2014

Last Modified: 14/10/2014 08:19

Dale Roberts (c) 2011-2014

Last Modified: 14/10/2014 08:19

Dale Roberts (c) 2011-2014

Last Modified: 14/10/2014 08:19

Dale Roberts (c) 2011-2014

Last Modified: 14/10/2014 08:19

Dale Roberts (c) 2011-2014

Last Modified: 14/10/2014 08:19

Useful in probability theory as it allows one to handle continuous and

Dale Roberts (c) 2011-2014