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Abstract. Three approaches in obtaining the closed-form solution of the Vasicek bond
pricing problem are discussed in this exposition. A derivation based solely on the distribution of the short rate process is reviewed. Solving the bond price partial differential
equation (PDE) is another method. In this paper, this PDE is derived via a martingale
approach and the bond price is determined by integrating ordinary differential equations.
The bond pricing problem is further considered within the Heath-Jarrow-Morton (HJM)
framework in which the analytic solution follows directly from the short rate dynamics
under the forward measure.
Keywords: Bond pricing, Vasicek model, Martingales, HJM methodology, Forward
measure.
1.
Introduction
Vasiceks pioneering work (1977) is the first account of a bond pricing model
that incorporates stochastic interest rate. The short rate dynamics is modeled as a diffusion process with constant parameters. When the bond price
is based on this assumption, it has the feature that on a given date, the
ratio of expected excess return per unit of volatility (the market price of
risk) is the same, regardless of bonds maturity. Vasiceks model is a special version of Ornstein-Uhlenbeck (O-U) process, with constant volatility.
This implies that the short rate is both Gaussian and Markovian. The
model also exhibits mean-reversion and is therefore able to capture monetary authoritys behavior of setting target rates. Furthermore, historical
experience of interest rates justifies the O-U specification.
Given the pedagogical value of the Vasicek model in stochastic term structure modeling, the purpose of this paper is to present alternative derivation
of the bond price solution. From the bond price the entire yield curve can
be constructed at any given time. Thus, in turn, the term structure dynamics is characterized by the evolution of the short rate.
Requests for reprints should be sent to Rogemar S. Mamon, Department of Statistics,
University of British Columbia, Vancouver, BC, Canada V6T 1Z2.
R. S. MAMON
2.
In modeling the uncertainty of interest rates, assume that there is an underlying probability space (, F, P ) equipped with a standard filtration
{Ft }. Under the risk-neutral measure P, the short rate dynamics is given
by
drt = a(b rt )dt + dWt
(1)
where a, b and are all positive constants.
It can be verified using Itos formula that
Z t
Z t
at
au
au
rt = e
r0 +
abe du +
e dWu
0
ea(ut) dWu ,
= t +
0
Hence,
Z
t := E[rt ] = r0 +
(2)
From (2),
d
t = a(b t ),
dt
which is a linear ordinary differential equation (ODE). Consequently, using
the integrating factor eat
E[rt ] = eat [r0 + b(eat 1)] = t .
(3)
R. S. MAMON
(5)
(6)
X(u)du =
X(0)
(1 eat ).
a
(8)
Similarly,
Cov[X(t), X(u)] = 2 ea(u+t) E
= 2 ea(u+t)
Z
eas dWs
0
ut
eas dWs
e2as ds =
2 a(u+t) 2a(ut)
e
(e
1).
2a
Consequently,
Z t
Z t
Z t
V ar
X(u)du = Cov
X(u)du,
X(s)ds
0
0
0
Z t
Z t
Z t
Z t
=E
X(u)du E
X(u)du
X(s)ds E
X(s)ds
0
t
Z tZ
ru du
"Z
= V ar
(10)
X(u)du
t
2
(2a(T t) 3 + 4ea(T t) e2a(T t)(11)
)
2a3
R. S. MAMON
Thus,
"
! #
"
! #
Z T
ru du Ft = E exp
ru du rt .
t
B(t, T ) = E exp
t
We write
"
B(t, T, rt ) := E exp
t
! #
"
!#
Z T
ru du rt = E exp
ru (rt )du
.
t
(14)
(15)
t)
Since for all t, the yield log B(t,T,r
obtained from (13) is affine in rt ,
T t
equation (13) is called an affine term structure model or an exponential
affine bond price.
3.
Under this approach, the derivation is based on the fact that the ru process
is Markov. In other words, to determine how ru evolves from t we need
know only the value of rt , u t. Thus,
"
! #
Z T
B(t, T, rt ) = E exp
ru (rt )du rt
t
and
Z
ru = ea(ut) rt + b(ea(ut) 1) +
ea(vt) dWv .
With rt as a parameter,
ru (rt )
= ea(ut) .
rt
So
Z
t
ru (rt )
du =
rt
ea(ut) du =
1
(1 ea(T t) ),
a
which is deterministic.
Also,
"
!
!#
Z T
Z T
ru (rt )
B(t, T, rt )
= E
du exp
ru (rt )du
rt
rt
t
t
"
!#
Z T
1
a(T t)
= (1 e
)E exp
ru (rt )du
a
t
= A(t, T )B(t, T, rt ),
where A(t, T ) is given as in (14).
B
Thus, r
= AB. So,
t
B(t, T, rt ) = C(t, T )exp(A(t, T )rt ),
for some function C independent of rt .
Consider
"
Z t
Z
exp
ru (rt )du B(t, T, rt ) = E exp
0
! #
ru du Ft .
R. S. MAMON
exp
rv dv
B(u, T, ru )du
+
u
0
0
Z u
Z t
+
exp
rv dv
B(u, T, ru )(a(b ru )du + dWu )
ru
0
0
Z u
2
Z
1 t
+
exp
rv dv
B(u, T, ru ) 2 du.
2
2 0
r
0
u
Since this is a martingale, all the du terms must sum to zero. So,
B(t, T, rt ) +
B(t, T, rt )(a(b rt ))
t
rt
2 2
+
B(t, T, rt ) = 0.
2 rt2
rt B(t, T, rt ) +
(16)
Equation (16) is the PDE for the bond price in the Vasicek model. Moreover, this is a backward parabolic equation with B(T, T, rt ) = 1 for every
rt .
So far we know
B(t, T, rt ) = C(t, T )exp(A(t, T )rt ).
Therefore, we get the following partial derivatives.
B
C
A
=
exp(A(t, T )rt ) C
rt exp(A(t, T )rt )
t
t
t
B
= ACexp(A(t, T )rt )
rt
2B
= A2 Cexp(A(t, T )rt )
rt2
So, substituting to the PDE in (16) we have
C
A
exp(Art ) C
rt exp(Art )
t
t
2 2
ACexp(Art )(a(b rt )) +
A Cexp(Art ) = 0.
2
rt Cexp(Art ) +
Therefore,
rt C +
A
2 2
C
C
rt AC(a(b rt )) +
A C = 0.
t
t
2
2a(T t)
a(T t)
+ 3 (1 e
) 3 (1 e
) .
4a
a
Write
D(t, T ) := log C(t, T ).
We see that this reconciles with the second to the last terms of equation
(12) and hence with the expression of equation (15). Under this approach,
we have
B(t, T, rt ) = exp(A(t, T )rt + D(t, T ))
where A(t, T ) is given by (14).
4.
10
R. S. MAMON
T
Xexp t ru du
Ft .
= E
B(t, T )
(19)
(21)
Comparing (20) and (21), in terms of the short rate model, the forward
rate is given by
f (t, T ) = E T [rT |Ft ]
(22)
where E T denotes the expectation under P T .
11
(23)
Thus,
2
E u [ru |Ft ] = rt ea(ut) + b 2 (1 ea(ut) )
2a
2
+
(ea(ut) e2a(ut) ).
2a2
So,
Z
t
rt h a(ut) iT
2
E [ru |Ft ]du =
e
+ b 2 (T t)
a
2a
t
T
2
1
b 2
ea(ut)
2a
a
t
T
T
2
2
a(ut)
2a(ut)
+
e
2a3
4a3
t
t
rt
2
a(T t)
=
(1 e
) + b 2 (T t)
a
2a
2
a(T t)
1e
2
b 2
+ 3 (1 ea(T t) )
2a
a
2a
2
3 (1 e2a(T t) )
4a
2
= rt A(t, T ) + b 3 [(T t) + A(t, T )]
2a
a(T t) 2
2 1e
+
.
a
u
12
R. S. MAMON
Therefore,
Z
B(t, T, rt ) = exp
f (t, u)du
Z
= exp
Conclusion
13
t
T
t Ft .
JT
HT
Jt
T
In particular, t = H
Ht JT for t < T. Suppose that the process under some
measure P associated with numeraire Ht is given by dXt = m(Xt , t)dt +
(Xt , t)dWt for some functions m(Xt , t) and (Xt , t). We are interested on
the process followed by Xt under another measure Q with numeraire Jt .
Q
Jt
T
Consider t,T = H
Ht JT . From Girsanovs theorem, if Wt is a Wiener
R
t
process under Q, WtQ = WtP 0 u du where dt,T = t,T T dWTP and t
can be determined. Moreover, conditional upon Ft , t,T is a process in T.
Let Ht and Jt have dynamics under P given by
dWTP .
T
JT
HT
14
R. S. MAMON
=
exp
ru du .
J s HT
B(s, T )
s
)
Under measure P, dB(t,T
B(t,T ) = rt dt + B (t)dWt for some function B (t).
It is a straightforward calculation to show that the process t = s,t ,
conditional upon Fs , satifies
dt
dB(t, T )
=
rt dt = B (t)dWt .
t
B(t, T )
Rt
This implies that WtQ = WtP 0 B (u)du. Hence, if under P we have
the dynamics dXt = m(Xt , t)dt + (Xt , t)dWtP then the Qprocess for Xt
is dXt = (m(Xt , t) + B (t)(Xt , t))dt + (Xt , t)dWtQ .
Equation 23 follows from this result with X = r, Q = P T , (Xt , t) = ,
B (t) = A(t, T ) and m(Xt , t) = a(b rt ).
Special Issue on
Time-Dependent Billiards
Call for Papers
This subject has been extensively studied in the past years
for one-, two-, and three-dimensional space. Additionally,
such dynamical systems can exhibit a very important and still
unexplained phenomenon, called as the Fermi acceleration
phenomenon. Basically, the phenomenon of Fermi acceleration (FA) is a process in which a classical particle can acquire
unbounded energy from collisions with a heavy moving wall.
This phenomenon was originally proposed by Enrico Fermi
in 1949 as a possible explanation of the origin of the large
energies of the cosmic particles. His original model was
then modified and considered under dierent approaches
and using many versions. Moreover, applications of FA
have been of a large broad interest in many dierent fields
of science including plasma physics, astrophysics, atomic
physics, optics, and time-dependent billiard problems and
they are useful for controlling chaos in Engineering and
dynamical systems exhibiting chaos (both conservative and
dissipative chaos).
We intend to publish in this special issue papers reporting
research on time-dependent billiards. The topic includes
both conservative and dissipative dynamics. Papers discussing dynamical properties, statistical and mathematical
results, stability investigation of the phase space structure,
the phenomenon of Fermi acceleration, conditions for
having suppression of Fermi acceleration, and computational
and numerical methods for exploring these structures and
applications are welcome.
To be acceptable for publication in the special issue of
Mathematical Problems in Engineering, papers must make
significant, original, and correct contributions to one or
more of the topics above mentioned. Mathematical papers
regarding the topics above are also welcome.
Authors should follow the Mathematical Problems in
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.hindawi.com/journals/mpe/. Prospective authors should
submit an electronic copy of their complete manuscript
through the journal Manuscript Tracking System at http://
mts.hindawi.com/ according to the following timetable:
Manuscript Due
December 1, 2008
March 1, 2009
Publication Date
June 1, 2009
Guest Editors
Edson Denis Leonel, Departamento de Estatstica,
Matemtica Aplicada e Computao, Instituto de
Geocincias e Cincias Exatas, Universidade Estadual
Paulista, Avenida 24A, 1515 Bela Vista, 13506-700 Rio Claro,
SP, Brazil ; edleonel@rc.unesp.br
Alexander Loskutov, Physics Faculty, Moscow State
University, Vorobevy Gory, Moscow 119992, Russia;
loskutov@chaos.phys.msu.ru