Modelling Interest Rates: Autumn 2 0 0 9

A U T U M N 2 0 0 9
MODELLING INTEREST RATES
Numerical Methods in Finance (Implementing Market Models)

COMPUTATIONAL FINANCE
MSc
©Finbarr Murphy 2007
Lecture Objectives
 Modelling Interest Rates
 Fitting the BDT Curve
MSc
Agenda
Page
1
Constructing Binomial Trees for the Short 2
Rate
2
Term Structure Consistent Models 10
3
MSc
3
Constructing Binomial Models for the Short Rate

 Most of the interest rate models discussed have
limited or no analytical solutions for derivatives
priced on the SDE’s
 Numerical solutions must be used, particularly for

those derivatives with early exercise
opportunities and non-standard terminal payoff
profiles
 We will look at binomial trees and how these can

be constructed to model the short rate and…
 Price interest rate derivatives

MSc
4

 For pricing interest rates, the trees are
constructed in a similar manner to those of the
equity variety except that the interest rate
changes..
 Obviously!
MSc
5

 We break the yield curve into i = 1,…,N segments
of length Δt
 We use the following familiar conventions

 P(i) = price at time t=0 of a pure discount bond maturing
at iΔt
 R(i) = yield at time t=0 of a pure discount bond maturing
at iΔt
 σR(i) = volatility at time t=0 of R(i)
MSc
6

 Although we could build a binomial tree for any of
the short rate processes covered, we will follow
C&S and model the BDT90 process. I.e.
 σ ' (t ) 
d ln r (t ) = θ ( t ) + ln r ( t )  dt + σ ( t ) dz
 σ (t ) 
MSc
7

 The initial short rate, r, is the yield on the bond
that matures at the end of Δt
 In the 2-step model here, we need rUU
to pick rU and rD so that the bond at rU
2Δt has a value of 1

r rUD
rD
 In considering how we can fit the
rDD
grid to the initial curve, we must

also consider the initial volatility
curve
MSc
8

 Jamshidian (1991) showed that the level of the
short rate at time t in the BDT model is given by:
r(t ) = U (t )e σ ( t ) z(t )
E.q. 9.2.1
 Where
 U(t) is the median of the lognormal distribution for r at
time t
 σ(t) is the level of the short rate volatility
 z(t) is the level of the Brownian motion
 If we plan to fit both the yield curve and the

volatility curve, we must determine U(t) and σ(t)
at each time step
MSc
9

 Looking again at the binomial process
j=N
j=2 rUU
rU
j=1
j=0 r rUD
j=-1
rD
j=-2 rDD
j=-N
MSc
i=0 i=1 i=2 i=N-1 i=N 10


 At i = N, j√Δt is distributed with a mean of 0 and a
variance N
 Therefore, as Δt→0, the binomial process j√Δt

converges to the Weiner process z(t)
 Using this result with Eq. 9.2.1, we can say
ri , j = U ( i ) e σ ( t ) j ∆t
E.q. 9.2.2
 In order to determine U(i) and σ(i) we again use

state prices
MSc
11

 Recall that Qi,j is the value at time = t of a security
that pays 1 if node i,j is reached or zero
otherwise
 These state prices can be thought of as

discounted probabilities, given a particular state
 Jamashidian used a process of forward induction

to accumulate state prices as one moves forward
through the tree

MSc
12

 Clearly Q0,0 = 1
 Let di,j represent the discount factor at node i,j
1
di , j = Q2,2
1 + ri , j ∆t Q1,1
Q0,0 Q2,0
 For simple compounding Q1,-1
 Q2,0 = ½Q1,-1d1,-1+ ½Q1,1d1,1 Q2,-2
 In general
Qi , j = 12 Qi −1, j −1d i −1, j −1 + 12 Qi −1, j +1d i −1, j +1

MSc
13

 This doesn’t work for the outer nodes so we have
Qi ,i = 12 Qi −1,i −1d i −1,i −1

Qi , −i = 12 Qi −1, − i +1d i −1, −i +1
 We will implement a model to fit the yield curve

and the volatility curve but first
 We assume that the volatility curve is constant

MSc
14

 This means the BDT90 process becomes
d ln r (t ) = θ ( t ) dt + σdz
 And Eq 9.2.2 becomes
ri , j = U ( i ) e σj ∆t
E.q. 9.2.3
MSc
15

 The price of a pure discount bond maturing at Δt
is given by Q1,1
d1,1
P(0) = Q1,1d1,1+Q1,-1d1,-1
Q0,0
d0,0
 And in a general sense
P( i + 1) = ∑ Qi , j d i , j
Q1,-1
d1,-1
Δt
j
 So
1
P( i + 1) = ∑ Qi , j
j 1 + ri , j ∆t
MSc
16

 And
1
P( i + 1) = ∑ Qi , j
j [
1 + U (i)e σj ∆t
]∆t
 If P(i+1) is known, all other factors are known
except U(i)
 We can estimate U(i) using a numerical search

method such as Newton Raphson

MSc
17

 The code is listed in BDT90CurveFit.m
 I used a home-grown search method as I found

that the nature of the Σ was difficult to put in a
matlab function such as
MSc
18

 Once we have U(i) we can estimate the short rate
ri,j and the discount factors di,j by
ri , j = U ( i ) e ( σj ∆t )
1
di, j =
1 + ri , j ∆t
MSc
19

 I have generated the same results as those in
Figure 8.4, page 239 in C&S
MSc
20

 The next step is to create extend the model to fit
the existing yield curve and volatility curve
 Now, the level of the short rate at i,j is given by

ri,j
ri , j = U ( i ) e ( σ (i) j ∆t )
Q0,0 Pu(i)
d0,0
Pd(i)
Δt
MSc
21

 Pu(i) and Pd(i) are up and down discount functions
 These must be consistent with the yield curve, so
1
P( i ) = [ 12 PU ( i ) + 12 PD ( i ) ]
1 + r0 , 0 ∆t
 Initial volatilities of the short rate are given by

1 ln PU ( i )
σR( i ) ∆t = ln
2 ln PD ( i )
MSc
22

 By working with the existing forward induction
techniques and the two equations from the
previous slide
 We can work to fit the volatility curve

MSc
23
Recommended Texts
 Required/Recommended
 Clewlow, L. and Strickland, C. (1996) Implementing derivative
models, 1st ed., John Wiley and Sons Ltd.
— Chapter 8
 Additional/Useful
MSc
24

Modelling Interest Rates: Autumn 2 0 0 9

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Modelling Interest Rates: Autumn 2 0 0 9

Uploaded by

Copyright:

Available Formats

A U T U M N 2 0 0 9

MODELLING INTEREST RATES

Numerical Methods in Finance (Implementing Market Models)

Constructing Binomial Models for the Short Rate

 Numerical solutions must be used, particularly for

 We will look at binomial trees and how these can

 Price interest rate derivatives

Constructing Binomial Models for the Short Rate

Constructing Binomial Models for the Short Rate

 We use the following familiar conventions

Constructing Binomial Models for the Short Rate

Constructing Binomial Models for the Short Rate

to pick rU and rD so that the bond at rU

2Δt has a value of 1

grid to the initial curve, we must

Constructing Binomial Models for the Short Rate

 z(t) is the level of the Brownian motion

 If we plan to fit both the yield curve and the

Constructing Binomial Models for the Short Rate

i=0 i=1 i=2 i=N-1 i=N 10

Constructing Binomial Models for the Short Rate

 Therefore, as Δt→0, the binomial process j√Δt

 Using this result with Eq. 9.2.1, we can say

 In order to determine U(i) and σ(i) we again use

Constructing Binomial Models for the Short Rate

 These state prices can be thought of as

 Jamashidian used a process of forward induction

through the tree

Constructing Binomial Models for the Short Rate

 Let di,j represent the discount factor at node i,j

 Q2,0 = ½Q1,-1d1,-1+ ½Q1,1d1,1 Q2,-2

Qi , j = 12 Qi −1, j −1d i −1, j −1 + 12 Qi −1, j +1d i −1, j +1

Constructing Binomial Models for the Short Rate

Qi ,i = 12 Qi −1,i −1d i −1,i −1

 We will implement a model to fit the yield curve

and the volatility curve but first

 We assume that the volatility curve is constant

Constructing Binomial Models for the Short Rate

 And Eq 9.2.2 becomes

Constructing Binomial Models for the Short Rate

Constructing Binomial Models for the Short Rate

 We can estimate U(i) using a numerical search

method such as Newton Raphson

Constructing Binomial Models for the Short Rate

 I used a home-grown search method as I found

Constructing Binomial Models for the Short Rate

Constructing Binomial Models for the Short Rate

Constructing Binomial Models for the Short Rate

 Now, the level of the short rate at i,j is given by

Constructing Binomial Models for the Short Rate

 These must be consistent with the yield curve, so

 Initial volatilities of the short rate are given by

Constructing Binomial Models for the Short Rate

 We can work to fit the volatility curve

You might also like