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In this lecture. . .
the theoretical yield curve and the market yield curve, should
they be the same?
This theoretical yield curve will not be the same as the yield
curve seen in the market.
It is good if. . . you believe your theoretical model and you are
looking for arbitrage opportunities among simple instruments.
(If your model output matched market prices then youll never
nd any arbitrage!)
The Ho & Lee spot interest rate model is the simplest that can
be used to fit the yield curve.
Recap: In the Ho & Lee model the process for the risk-neutral
spot rate is
dr = (t)dt + c dX.
T
2 3
A(t; T ) = (s)(T s)ds + 1
6 c (T t) .
t
(Note that the variables are r and t, but we are also explicitly
referring to the parameter T , the bond maturity.)
That is calibration!
ZM (t; T ) = eA(t ;T )r (T t ) .
T
(s)(T s)ds = log(ZM (t; T )) r(T t) + 1
6 c2
(T t 3
) .
t
(1)
d T T
(s)(T s)ds = (s)ds.
dT t t
Dierentiate again
d2 T
(s)(T s)ds = (T ).
2
dT t
2
(t) = c (t t ) 2 log(ZM (t; t)).
2
t
The solution!
With this choice for the time-dependent parameter (t) the the-
oretical and actual market prices of zero-coupon bonds are the
same.
Now that we know (t) we can price other xed income in-
struments.
We say that our prices are consistent with the yield curve.
Most one-factor models have the potential for tting, the more
tractable the model the easier the tting. If the model is not at
all tractable then we can always resort to numerical methods.
dr = ( r)dt + c dX.
and
1 (T t)
B(t; T ) = 1e .
T
(s)B(s; T )ds
t
c2 2 (T t )
1 2(T t ) 3
+ 2 T t + e e
2 2 2
2 c2
2(tt)
(t) = 2 log(ZM (t ; t)) log(ZM (t ; t))+ 1e .
t t 2
(3)
(Please dont get the idea from this that all models are easy to
calibrate or all integral equations are easy to solve!)
T
i
T
i- 1
Time
First 1:
T
1
1(T1 s)ds = 1 T 2 = log(Z (0; T )) r T + 1 c2T 3 .
2 1 1 M 1 1 6 1
0
Therefore
2 1 2 3
1 = 2 log(ZM (0; T1)) r T1 + 6 c T1 .
T1
T T
2(T2s)ds = log(ZM (0; T2))rT2+ 1
1 2 2 3
1(T2s)ds+ 6 T2 .
c
0 T1
2 2 2
= 2 1 T2 (T2 T1) + 1
1
2 2 (T2 T1 ) .
Therefore
2
1 c2 T 3
2 = log(Z M (0; T2 )) r T2 + 2
(T2 T1)2 6
1 2 2
2 1 T2 (T2 T1) .
j
T
i
i Tj s ds
i=1 Ti1
j
2 2
=1
2 i Tj Ti1 Tj Ti .
i=1
2 j1
2 2
=1
2 j Tj Tj1 +1
2 i Tj Ti1 Tj Ti .
i=1
2
j = 2 log ZM (0; Tj ) rTj + 1 2 3
6 Tj
c
Tj Tj1
j1
2 2
1 i Tj Ti1 Tj Ti
2
i=1
0.02
Original eta(t), at time of fitting
0.015
0.01
Eta(t)
0.005
0
-1 1 3 5 7 9 11 13 15
-0.005
-0.01
Time
0.015
0.01
Eta(t)
0.005
0
-1 1 3 5 7 9 11 13 15
-0.005
-0.01
Time
0.01
Eta(t)
0.005
0
-1 1 3 5 7 9 11 13 15
-0.005
-0.01
-0.015
Time
For
The one (or more)-factor models for the spot interest rate that
we have seen were all chosen for their nice properties; for most
of them we were able to nd simple closed-form solutions of the
bond-pricing equation.
Clearly, this means that the models are not necessarily a good
description of reality.
the spot rate is well behaved (i.e. doesnt wander too far
away, go to zero or innity for example)
0
14/11/1984 11/08/1987 07/05/1990 31/01/1993 28/10/1995 24/07/1998
Our rst observation is that many popular models take the form
From the time-series data divide the changes in the interest rate,
r, into buckets covering a range of r values.
0
14/11/1984 11/08/1987 07/05/1990 31/01/1993 28/10/1995
0.6
0.4
0.2
0
14/11/1 29/03/1 11/08/1 23/12/1 07/05/1 19/09/1 31/01/1 15/06/1 28/10/1 11/03/1
984 986 987 988 990 991 993 994 995 997
-0.2
-0.4
-0.6
-0.8
0.035
0.03
0.025
0.02
0.015
0.01
0.005
0
14/11/1 29/03/1 11/08/1 23/12/1 07/05/1 19/09/1 31/01/1 15/06/1 28/10/1 11/03/1
984 986 987 988 990 991 993 994 995 997
E[(r)2] = 2r2 t
to leading order in the time step t, which for our data is one
day.
The slope of this line gives an estimate for 2 and where the
line crosses the vertical axis can be used to nd .
-0.6
-1.1
-1.6
-2.1
Estimation of
Our approach to nding the drift function is via the empirical and
analytical determination of the steady-state probability density
function for r.
p 1 2 2 2
= 2 2
(r p) (u(r)p). (6)
t r r
d
u(r) = 2r21 + 2 1
2 r 2
(log p).
dr
0.18
0.16
0.14
0.12
0.1
0.08
0.06
0.04
0.02
0
1
11
13
15
17
19
21
23
25
27
This gure shows empirical data, the bars, and a tted function,
the line.
1 1
r))2
exp 2 (log(r/
ar 2 2a
2 21 1 1
u(r) = r 2 log(r/
r) .
2 2a
We will examine the short end of the curve for this information.
Z 2Z Z
1 2
+ 2 w(r, t) + (u(r, t) (r, t)w(r, t)) rZ = 0.
t r2 r
2 2
Z(r, t; T ) 1 r(T t) + 1
2 (T t) (r u + w) + . . . as t T.
ln Z
r+1
2 (u w)(T t) + . . . as t T. (8)
T t
The rst term says that the short end of the yield curve is r
(obvious!), and the second term says that the slope of the yield
curve at the short end in this one-factor model is simply (u
w)/2.
0
0 2 4 6 8 10 12
-2
-4
-6
10
0
29/03/1986 11/08/1987 23/12/1988 07/05/1990 19/09/1991 31/01/1993 15/06/1994 28/10/1995
Lambda
-5
-10
-15
-20
-25
Time
Forward rates
0.1
0.08
Rates
0.06
0.04
0.02
0
0 2 4 6 8 10
Time
0.08
Rates
0.06
0.04
0.02
0
0 2 4 6 8 10
Time
0.08
Rates
0.06
0.04
0.02
0
0 2 4 6 8 10
Time