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Marco Marchioro
www.marchioro.org
Lecture Summary
• No-arbitrage models
Equilibrium models
No arbitrage models
Simplest example:
drt = θ(t) dt + σ dWt (2)
where the function θ(t) can be determined so that the discount factor
is modeled exactly.
Hull-White model
rt = xt + y(t) =
σ2 t Z
−a −a −a(t−s) dW
= f (t) + [r0 − f (0)] e t + 1 − e t + σ e s
2 a2 0
We can compute average and variance
σ2 −a t
hrti = r0 + f (t) − f (0) + 1−e (11)
2 a2
D
2
E σ2 −2a t
(rt − hrti) = 1−e (12)
2a
• Mean-reverting model
• Known price for a zero-coupon bond
• Discount curve obtained exactly
• Known price for options on a zero-coupon bond
• Swaptions are computable using Jamshidian decomposition
• Easy to calibrate on quoted volatilities for Caps/Floors or Swap-
tions (need to choose one or the other)
• Quite easy to be solved numerically for American-style options
(e.g., using a trinomial tree)
Black-Karasinski model
Questions?
Reference:
• Monte Carlo methods in financial engineering, Paul Glasserman,
Springer Finance (Stochastic modeling and applied probability)
(courtesy of http://www.wikipedia.org)
Advanced Derivatives, Interest Rate Models 2010–2012
c Marco Marchioro
Market interest-rate models 19
Questions?
Examples
• Black model for Cap pricing: it is assumed that the Libor rates
at the reset dates of a Cap have a log-normal distribution. Only
few instruments can be priced this way
• Libor market model: similar to the Black model but all the for-
ward rates are considered simultaneously. Forward measures are
properly accounted for
• Has been used in the industry long before its publication (see,
e.g., Rebonato)
Change of measure
j j+1 τj σj Lj
dWt = dWt − dt (21)
1 + τj Lj
Since equation,
dxt = M dt + v xt dZt (24)
has a solution
v2
( ! )
h i
x(Tj+1) = x(Tj ) exp M− τj + v Z(Tj+1) − Z(Tj ) (25)
2
Advanced Derivatives, Interest Rate Models 2010–2012
c Marco Marchioro
Market interest-rate models 28
The same random number εj should be used for all Libor rates Li
Advanced Derivatives, Interest Rate Models 2010–2012
c Marco Marchioro
Market interest-rate models 29
Starting with the Libor rates Lj (T0)’s observed on the Libor curve at
the current time, i.e. T0, we first determine the Libor rates at the
next reset date T1 using (22) and continue in this way until all Libor
rates are simulated.
Questions?
Stochastic-volatility models
Questions?
References