Rate and Volatility Times - 1

Review Sheet: Interest Rate Time, Volatility Time, and

Exponential/Natural Log Functions
T
B bill/note/bond price in nominal terms of a zero coupon claim that matures at
time T, the current (spot) price, also bond/note/bill
T
PV .
T
R simple interest rate in nominal terms for funds invested or lent to time T. For
intervals T less than or equal to a year, the rate is a simple interest rate.
For intervals T greater than a year, the rate is on a periodic bond-equivalent
zero coupon basis.
T
Z Zero coupon continuously compounded interest rate for funds invested in
zero coupon bonds (strips) or borrowed in a zero coupon issue for maturity
T.
All other borrowed (short) and invested (long) bonds are aggregates of the
T
B s.
T < 1 year,
T
B =
( ) +
T
1
1 R * T
=
*
T
-Z T
e

Example =1%,
1
R
1
B =
( )

= =
+
=
1
0.0099503*1
1
1 0.01*
0.9901 e ,Z 0
1
.99503%
( )
=
T T T T
Given market R , solve for Z : Z ln 1+R T / T,
( )
=
T
Z
T
Z ln e , ln inverseof e
Continuous discounting is maximal. Given
T
B ,
T
Z <
T
R . Quoted rates drop as
compounding grows more frequent:
( )
= =
+
+
> =
1 1,2
2
1
1,2
1 1
,
1
1 R
1 R 2
B R R 0.9975%
,
( )

= = =
>
+
R Z
1, 1
n
1,
1
Lim
e e
n
1 R n

Analogous to compounding, borrowing or investment can be split into a current/spot
and forward component. For 1% six month and one year simple rates, a forward
six month rate into the remaining six months of the year is implied, :
1/2 1
R .
( ) ( ) ( )

= = =
+ + +
1/ 2 1/ 2 1 1
z 2 z 2 z
1 1/2 1/ 2 1
1 1 1
e e e
1 R 1 R 2 1 R 2

Solving
| | +
= =
|
+
\ .
1
1/ 2 1
1/ 2
1
0.9
R
2 1
1
95 ,
R 2
02% R ( ) = =
1/2 1 1/2 1
Z 2 ln 1+ R 2 0.992558%


Rate and Volatility Times - 2

Evolving, maturity T is broken up into n pieces, and h=T/n is each interval length. In
an interval, a normal random draw moves the price up or down. Volatility doesnt
grow with interest rate time, in t, but in the square root of time, t .
t h
v h
.
t h t h
S S e , v ~N(0,1)
+
o
+
=
This equation updates value in each interval.
Since we must take logs to standardize the relation, the type of value evolution is called log-normal:
( )
h 0 h h
Ln S S v h, v ~N(0,1). = o We use the square root because it matches the growth of risk/standard deviation
with reality, and because the formulation leads to the elegant Ito process for security prices. There are two logical
conditions needed for a successful process definition: 1) the series is reasonable over time, and 2) the value
outcomes at any maturity should match the observed distribution of outcomes:
For example, we have 10 normal observations a day for a year, and the first day v
h
s are :
{1.00643,0.38259,0.20658,0.73489,0.67623,0.79946,0.63541,0.75845,0.09569,0.58244}
Multiplying each observation by the 10% volatility, o=0.1, and the Sqrt[1/3600]=1/60 of the h interval, we raise e by this
power, for the daily capital gain loss factors:
{0.99832,0.99936,0.99966,1.00123,0.99887,0.99867,0.99894,0.99874,0.99984,1.00097}
We compound these daily factors for the value of the $1 in each of the 10 days:
{1.,0.99832,0.99769,0.99734,0.99857,0.99744,0.99611,0.99506,0.9938,0.99364,0.99461}
Random Normal, v
h

2 4 6 8 10
-1.0
-0.5
0.5

Value Sequence
2 4 6 8 10
0.995
0.996
0.997
0.998
0.999
1.000


One year of values
500 1000 1500 2000 2500 3000 3500
1.05
1.10
1.15

Five hundred such outcomes:
500 1000 1500 2000 2500 3000 3500
0.8
0.9
1.0
1.1
1.2
1.3
1.4




End of First Quarter (Black 900
intervals), and Year End (Blue
3600 Intervals) Outcomes