PARAMETRIC ESTIMATION FOR TREASURY BILLS

DEJUN XIE

Abstract. In this work we apply the maximum likelihood method to find the parameter esti-
mations for the Vasicek short term interest model. To run the experiment, the historical data
of 10-year treasury notes from 1966 to 2006 are used. The unbiasedness and biasedness of the
estimation are discussed.

1. introduction

We assume that the overall rate of return that the bond issuer can earn from its investment
follows the Vasicek model. In the Vasicek model [9], the yield rt at time t is treated as a Markov
process, governed by the stochastic differential equation
drt = k(θ − rt )dt + σdWt
where k, θ, and σ are positive parameters and {Wt } is the standard Wiener (Brownian) process.
The Vasicek model is composed of one deterministic term and one random term. The de-
terministic term (also ”the drift term”) is chosen to produce the so called ”mean-reverting”
property. And the random term is to model the volatility caused by (possibly infinite) un-
predictable factors. Specifically, θ is the long term mean of the spot interest rate, σ is the
instantaneous standard deviation, and k is the speed measuring how fast the process will be
reverted back to the mean once it evolves away from the mean.
Besides these nice physical features, the Vasicek model is also very tractable from mathemat-
ical point of view. Suppose we know the interest rate at time τ is rτ , and the interest process
is governed by the Vasicek model. Using integrating factor method, one can solve the stochastic
differential equation and get the explicit (stochastic) solution for the interest rate at any time
t>τ .

Z t
−k(t−τ )
(1.1) rt = θ + e (rτ − θ) + σ e−k(t−τ −u) dWu
τ
A standard theory in stochastic calculus tells us that rt is a Gaussian process with mean
(1.2) Mean[rt |rτ ] = θ + e−k(t−τ ) (rτ − θ)
and variance
σ2
(1.3) Variance[rt |rτ ] = (1 − e−2k(t−τ ) )
2k
The author thanks the National Science Foundation grant DMS-0203991 for partially supported the research.
1

Electronic copy available at: http://ssrn.com/abstract=1105108

2 DEJUN XIE

Since rt is a normal distribution, the first two moments given in (1.2) and (1.3) are sufficient
to determine the the probability density function of the process. Starting from an initial rate
rτ = x, at a later time t (t > τ ), the probability density p for the rate rt to be equal to y is
given by
s
k ³ k[(y − θ) − (x − θ)e−k(t−τ ) ]2 ´
p(τ, x; t, y) = exp − .
πσ 2 (1 − e−2k(t−τ ) ) σ 2 (1 − e−2k(t−τ ) )
Instead of using the first two moments and Guassian property of the process, one can also use
the Kolmogorov equation to derive the probability density function. Let s = t − τ , From the
Kolmogorov equation, we have that the probability density for rt in the Vasicek model satisfies

 2 2
 ∂p = σ ∂ p − ∂ [k(θ − y)p],
∂s 2 ∂y 2 ∂y

p(τ, x; τ +, y) = δ(x − y).

One can easily solve this PDE by the standard Fourier transform method, or alternatively,
one can transform the equation into a standard heat equation.

2. Maximum Likelihood Derision

To determine the values of the parameters k, θ, σ in the model, we use the method of max-
imum likelihood. This is possible because, as introduced in previous section, the transitional
probability density function of the process is explicitly solved.

Let
k
α= ,
σ 2 (1 − e−2kt
β = 1 − e−kt ,
θ = θ,

and define
√ 1
(2.1) P := ln p = − ln π + ln α − α[(x − y) + β(θ − x)]2
2
Differentiate P w.r.t. α, β and θ, we have


 ∂P 1

 = − [(x − y) + β(θ − x)]2

 ∂α 2α




 ∂P
= −2α[(x − y) + β(θ − x)](θ − x)
 ∂β







 ∂P

 ∂θ = −2α[(x − y) + β(θ − x)]β

Electronic copy available at: http://ssrn.com/abstract=1105108

 PARAMETRIC ESTIMATION FOR TREASURY BILLS 3

Let N be the data sample size, which refers to the data size of treasury bills in our investigation.
Suppose we have a list {(ti , ri )}ni=0 of rates of return ri at time ti . For simplicity we assume
ti+1 − ti = t, i.e. the samples are taken at equal length time intervals. Now can take

X = (r0 , · · · , rn−1 ), Y = (r1 , · · · , rn )

and use these data to estimate the parameters k, θ, and σ for the Vasicek model.

For a given set of {t, Xi , Yi }ni=1 , by the definition of Maximum Likelihood, we need to find the
parameters α, β and θ such that

 n
 N X

 − [(xi − yi ) + β(θ − xi )]2 = 0



 2α

 i=1



 n

 X
(2.2) (θ − xi )[(xi − yi ) + β(θ − xi )] = 0

 i=1







 Xn

 [(xi − yi ) + β(θ − xi )] = 0


 i=1

Remark 2.1. Strictly speaking, we should use, say, k̄, θ̄, and σ̄ instead of k, θ, and σ in the
above equations, since they are the estimators, not the true values, of the known parameters k,
θ, and σ. Keep this in mind, we keep using k, θ, and σ to ease the notations.

The above system is theoretically easy to solve, although the calculation itself is tedious. We
hereby only provide the solutions, with the lengthy computation omitted.
4 DEJUN XIE

 n n n n n n n
 N X X X X X X X

 = ( x )2
(y 2
) + (x 2
)( y )2
+ 2 x y (xi yi )

 2α
i i i i i i



 i=1 i=1 i=1 i=1 i=1 i=1 i=1



 n n n

 X X X

 +N {( 2
xi yi ) − (xi ) 2
(yi )2 }



 i=1 i=1 i=1





 n n n

 X X X

 xi (xi − yi ) − N [xi (xi − yi )]

(2.3) i=1 i=1 i=1
 β= n n

 X X

 2
(xi ) − N (x2i )



 i=1 i=1





 X n X n X n X n



 xi (x i y i ) − N (x 2
) yi

 i

 i=1 i=1 i=1 i=1

 θ= n

 X X n X n

 xi (xi − yi ) − N [xi (xi − yi )]


 i=1 i=1 i=1

Translating α, β and θ back to the original parameters k, θ and σ, we have

n
X n
X
(xi )2 − N (x2i )
1 i=1 i=1
(2.4) k= ln n n n
t X X X
(xi ) (yi ) − N (xi yi )
i=1 i=1 i=1

n
X n
X n
X n
X
xi (xi yi ) − N (x2i ) yi
i=1 i=1 i=1 i=1
(2.5) θ= n n n
X X X
xi (xi − yi ) − N [xi (xi − yi )]
i=1 i=1 i=1

2 n X 2X 2
n n n
X Xn n
X n
X n
X
(2.6) σ2 = ( xi ) (yi ) + (x2i )( yi )2 + 2 xi yi (xi yi )
Nt
i=1 i=1 i=1 i=1 i=1 i=1 i=1
 PARAMETRIC ESTIMATION FOR TREASURY BILLS 5

Xn n
X n
X o
2 2 2
+N {( xi yi ) − (xi ) (yi ) }
i=1 i=1 i=1
n
X n
X
(xi )2 − N (x2i )
i=1 i=1
∗ n n n n n
X X X X X
(xi )2 − N 2
(xi ) − { (xi ) (yi ) − N (xi yi )}2
i=1 i=1 i=1 i=1 i=1
n
X n
X
(xi )2 − N (x2i )
i=1 i=1
∗ ln n n n
X X X
(xi ) (yi ) − N (xi yi )
i=1 i=1 i=1

The following Figure (2) is the output of our maximum likelihood estimation for the Vasicek
parameters using the real historical data of treasury notes.

3. the biased estimation of k

Maximum likelihood method is necessarily unbiased. For our problem in particular, it is

straightforward to see θ and σ are indeed unbiased statistics because they are i.i.d. random
variables. This is empirically verified by the fact that the parameters σ and θ in our programming
output are very stable and not sensitive to size of sampling. But k, which measures the speed
by which the interest rate is driven back to the long term mean θ , is a biased estimator.

To show this, it is easier to think the process as a continuous process (which is indeed true) and
assume we have continuous observations, thus we can write summations in terms of integral.

Define the likelihood process for k in the time interval [0 T ] associated with the Vasicek
interest model as
Z T Z
k(θ − rs ) 1 T k 2 (θ − rs )2
LT (k) = exp{ drs − ds, }
0 σ2 2 0 σ2
or

Z T Z T
k(θ − rs ) 1 k 2 (θ − rs )2
(3.1) ln[LT (k)] = 2
drs − ds,
0 σ 2 0 σ2
thus get

Z T Z T
∂
ln[LT (k)] = (θ − rs )drs − k (θ − rs )2 ds
∂k 0 0
∂
Without loss of generality, we assume, for simplicity, σ = 1, and let ln[LT (k)] = 0, we get
∂k
the usual maximum likelihood estimation equation for k:
6 DEJUN XIE

10 year Treasury Notes

BBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBB
From to sample mean StdDev k theta sigma
BBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBB
1996BB2006 daily 0.051 0.009 0.731 0.049 0.009
1996BB2006 weekly 0.051 0.009 0.769 0.049 0.009
1996BB2006 monthly 0.051 0.009 0.707 0.049 0.009

1986BB2006 daily 0.063 0.016 0.188 0.057 0.010

1986BB2006 weekly 0.063 0.016 0.198 0.058 0.010
1986BB2006 monthly 0.063 0.016 0.196 0.057 0.010

1976BB2006 daily 0.077 0.027 0.091 0.067 0.013

1976BB2006 weekly 0.077 0.027 0.098 0.068 0.013
1976BB2006 monthly 0.077 0.027 0.108 0.069 0.014

1966BB2006 daily 0.074 0.025 0.109 0.075 0.011

1966BB2006 weekly 0.075 0.025 0.117 0.075 0.012
1966BB2006 monthly 0.075 0.025 0.134 0.075 0.013

Figure 1. maximum likelihood parameter estimation using the historical data

of 10 year treasury notes.

RT
(θ − rs )drs
kT = R0T
0 (θ − rs )2 ds
But from the original stochastic Vasicek differential equation, we have

Z T Z T Z T
2
(θ − rs )drs = ktrue (θ − rs ) ds + (θ − rs )dWs
0 0 0
RT
Substitute above expression of 0 (θ − rs )drs into the righthand side of expression of kT , get

RT
(θ − rs )dWs
(3.2) kT = ktrue + R0T
2
0 (θ − rs ) ds
 PARAMETRIC ESTIMATION FOR TREASURY BILLS 7

where ktrue is the theoretical true value of the parameter we are estimating. Now to determine
if the kT is biased or unbiased, we only need to determine if
RT
(θ − rs )dWs
E[ R0T ]=0
(θ − r )2 ds
0 s
or not. Actually this is never true unless (θ − rs ) term (the drift term in the model) is constant:
by the Ito’s Isometry, we know that
Z T Z T
2
(θ − rs ) ds = [ (θ − rs )dWs ]2 ,
0 0
so RT
(θ − rs )dWs 1
E[ R0T ] = E[ R T ],
(θ − r )2 ds (θ − r )dW
0 s 0 s s
clearly the right side is never zero for finite T (some regularity argument provided) .

4. conclusion and discussion

Assume the short term interest rate follows the Vasicek model, we derived the transitional
probability density function using the Fourier transform method. We then applied the maximum
likelihood method to estimate the parameter values k, θ, and σ for the model. The biasedness
of the estimation for the parameter k is proved. As future research direction, it would be
interesting to investigate the asymptotic convergence of maximum likelihood estimation for this
model. And also, as a contrast, nonparametric density estimation can be alternatively applied.

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Department of Mathematics, University of Delaware , Newark, DE 19716, dxie@math.udel.edu