\documentclass{article} \usepackage{amsmath} \usepackage{fancyhdr} \usepackage{amsthm} \usepackage{amsfonts} \usepackage{cite} \usepackage{float} \theoremstyle{definition} \newtheorem{theorem}{Theorem} \newenvironment{sketchproof}{% \renewcommand{\proofname}{Sketch of Proof}\proof}{\endproof} \setlength{\parindent}{0pt} \begin{document} \section{Introduction} This model computes the prices of interest rate derivative securities. The model is based off risk-neutral interest rates following a Hull-White model which can fit the initial yield curve exactly. The real-world interest rate dynamics are assumed to follow a Vasicek (time-homogeneous Hull-White) process for simulation purposes. This framework is chosen for two reasons: it is efficient in pricing a wide range of interest rate options and it provides a suitable first approximation to the risk that may be incurred from movements in interest rates. Models that provide a better fit to market data (eg, the LIBOR Market Model) are not as flexible in pricing a variety of options. Models that generalize to multi-dimensional processes (eg, multi-dimensional Hull-White) are more difficult to estimate and are often less computationally efficient for pricing. \\ \\ Inputs to each pricing model include a function representing the initial yield curve and initial forward rate curve. \section{Assumptions} Like all pricing models, the assumption of NFLVR (No Free Lunch With Vanishing Risk) is used. This assumption allows the leveraging of the First Fundamental Theorem of Asset Pricing for pricing purposes (ie, all asset prices are martingales when denominated by another asset under a suitable measure and can be written as an expectation). It is assumed that there exists an asset \(M_t\) which satisfies \(dM_t=r_t M_t dt\) (ie, instantaneously riskless). Solving the ODE gives \(M_t=M_0 e^{\int_0 ^ t r_s ds}\). \\ \\ The variable \(r_t\) is assumed to follow a Vasicek (Ornstein Uhlenbeck) process: \[dr_t=a(b-r_t)dt+\sigma dW_t\] Here \(dW_t\) is an increment of Brownian Motion, \(a\) is the speed of mean reversion, \(b\) is the long run expected value of \(r_t\), and \(\sigma\) is the volatility of the process. This process is chosen for its simplicity and rough approximation of the actual interest rate process. \\ \\ By Girsonav's theorem, \(d\tilde{W}_t=dW_t-\frac{a(\theta(t)-b)}{\sigma}dt\) is a Brownian Motion under a suitable measure. Substituting into the equation for the short rate, \[dr_t=a(b-r_t)dt+\sigma\left(d\tilde{W}_t+\frac{a(\theta(t)-b)}{\sigma}dt\right)=a(\theta(t)-r)dt+\sigma d\tilde{W}_t\] Since this measure change is applicable for \(\sigma>0\), the model does not allow arbitrage and can be used for pricing interest rate securities. In particular, the time dependent parameter \(\theta\) can be calibrated to market data (the yield curve) and then used to price interest rate securities. \\ \\ By the Fundamental Theorem of Asset Pricing, the price of a zero coupon bond with par one is \[B(t, T)=M_t\mathbb{\tilde{E}}\left[\frac{1}{M_T}|\mathcal{F}_t \right]\] \[=\mathbb{\tilde{E}}\left[e^{-\int_t ^ T r_s ds}|\mathcal{F}_t \right]\] The final assumption is that the 7 day LIBOR rate is a reasonable proxy for the short rate \(r_t\) and that the LIBOR rates (implied or actual) from 1 month to 30 years are the yields on zero coupon bonds. From here on, \(M_t/M_T=e^{-\int_t ^ T r_s ds}\) will be denoted \(D(t, T)\). \section{Pricing Modules} The following ``generic'' functions are available: tree (lattice) methods (\ref{tree}), analytic Black Scholes formula (\ref{BS}), and Jamshidian's trick for finding options on a portfolio (\ref{Jamshidian}). From these generic functions, the fixed income derivatives can be priced. \subsection{Bond Price} Using the bootstrapped yield curve, any bond can be priced as of the current date. The cash flows are discounted at the zero coupon rate and summed. However, this does not facilitate the pricing of bonds at some future date. Hull and White showed that the price of a zero-coupon bond at a date \(t>0\) is \[B(t, T)=\frac{B(0, T)}{B(0, t)}e^{A(t, T)F(t)-\frac{\sigma^2}{4a}A^2 (t, T)\left(1-e^{-2at}\right)-A(t, T)r_t}\] Where \(A(t, T)=\frac{1-e^{-a(T-t)}}{a}\) and \(F(t)=-\frac{\partial \mathrm{log}(B(0, t))}{\partial t}\) is the instantaneous forward rate. The instantaneous forward rate is trivially computed from the spline. The time-dependent parameter \(\theta(t)\) is related to \(F(t)\) as follows:\[\theta(t)=\frac{1}{a} \frac{\partial F}{\partial t}+F(t)+\frac{\sigma^2}{2a^2}\left(1-e^{-2at}\right)\] \subsection{Black Scholes} \label{BS} Given a discount factor \(P(t, T)\) and an underlying asset \(S_T\) which is log-normally distributed, a vanilla option on \(S_T\) with strike \(k\) with maturity \(T\) and cumulative volatility \(\sigma \sqrt{T}\) is given by the Black Scholes formula. In particular, for a call option, \[C(S_t; k, t, T \sigma)=S_t \mathcal{N}(d_1)-kP(t, T)\mathcal{N}(d_1-\sigma \sqrt{T})\] Where \(d_1=\mathrm{log}\left(\frac{S_t}{kP(t, T)}\right)/\sigma \sqrt{T}+\frac{1}{2}\sigma \sqrt{T}\). \\ \\ In a fixed income setting, the underlying asset is a bond denominated by a bond of same tenor as the option. The discount factor and the asset are hence both bonds, and the ``\(\sigma\)'' is equal to the square root of the integral of the squared difference between the volatilities of the bonds; see (\ref{bondvolatility}). \subsubsection{Forward Measure} The forward measure can help facilitate pricing of caplets and options on bonds. Under this measure, the dynamics of a bond \(B(T, T+\delta)\) are \[d\frac{B(t, T+\delta)}{B(t, T)}\] \[=\left(\sigma(t, T+\delta)-\sigma(t, T)\right) \frac{B(t, T+\delta)}{B(t, T)}d\hat{W}_t\] Where \(\sigma(t, T)\) is the volatility of \(B(t, T)\). \subsubsection{Bond volatility} \label{bondvolatility} In the Hull-White model, the volatility of the bond price is deterministic: \(\sigma(t, T)=\frac{\sigma}{a}(1-e^{-a(T-t)})\) \[\implies \sigma(t, T+\delta)-\sigma(t, T)=\frac{\sigma}{a}e^{-a(T-t)}\left(1-e^{-a\delta}\right)\] Hence option pricing on the bond reduces to the Black Scholes formula with \[\sigma_{BS}=\sqrt{\frac{1}{T} \int_0 ^ T \left(\frac{\sigma}{a}e^{-a(T-t)}\left(1-e^{-a\delta}\right)\right)^2 dt}\] \[\sigma_{BS}=\frac{\sigma}{a}\left(1-e^{-a\delta}\right)\sqrt{\frac{1}{T} \int_0 ^ T e^{-2a(T-t)} dt}\] \[\sigma_{BS}=\frac{\sigma}{a}\left(1-e^{-a\delta}\right)\sqrt{\frac{1-e^{-2aT}}{2aT}}\] Note that the volatility depends only on \(a\) and \(\sigma\) and hence these parameters can be calibrated to the cap market. \subsection{Caplet and Bond option equivalency} The value of a caplet is \[\delta\mathbb{\tilde{E}}\left[D(t, T+\delta)\left(\frac{1-B(T, T+\delta)}{\delta B(T, T+\delta)}-k\right)^+ |\mathcal{F}_t\right]\] \[=\delta\mathbb{\tilde{E}}\left[D(t, T+\delta)\left(\frac{1}{\delta B(T, T+\delta)}-k-\frac{1}{\delta}\right)^+ |\mathcal{F}_t\right]\] \[=\delta\mathbb{\tilde{E}}\left[D(t, T)\left(\frac{ \mathbb{\tilde{E}}[D(T, T+\delta)|\mathcal{F}_T]}{\delta B(T, T+\delta)}-\mathbb{\tilde{E}}[D(T, T+\delta)|\mathcal{F}_T]\left(k+\frac{1}{\delta}\right)\right)^+ |\mathcal{F}_t\right]\] \[=\delta\mathbb{\tilde{E}}\left[D(t, T)\left(\frac{1}{\delta}-B(T, T+\delta)\left(k+\frac{1}{\delta}\right)\right)^+ |\mathcal{F}_t\right]\] \[=\left(\delta k+1\right)\mathbb{\tilde{E}}\left[D(t, T)\left(\frac{1}{\delta k+1}-B(T, T+\delta)\right)^+ |\mathcal{F}_t\right]\] \[=\left(k\delta+1\right)P\left(\frac{1}{\delta k +1}\right)\] Where \(P(\cdot)\) is a put on a bond with strike \(\cdot\). \subsection{Caplet pricing} From above, the price of a caplet is the following: \[c(t, T, \delta; k)=\left(k\delta+1\right)\mathbb{\tilde{E}}\left[D(t, T)\left(\frac{1}{\delta k+1}-B(T, T+\delta)\right)^+ |\mathcal{F}_t\right]\] \[=\left(k\delta+1\right)B(t, T)\mathbb{\hat{E}}\left[\left(\frac{1}{\delta k+1}-B(T, T+\delta)\right)^+ |\mathcal{F}_t\right]\] Where \(\hat{E}\) is the measure induced by \(B(t, T)\). The forward measure can then be used to price the option. \subsection{Euro Dollar Futures} The future price satisfies \[\delta f(t, T; \delta)=\tilde{\mathbb{E}}\left[\frac{1}{B(T, T+\delta)}|\mathcal{F}_t\right]-1\] In a Hull-White model, the future price is \[\delta f(t, T; \delta)=\frac{B(t, T)}{B(t, T+\delta)}e^{\gamma(t, T, \delta)}-1\] For some deterministic function \(\gamma\). This function is \[\int_t ^ T \sigma_B (s, T+\delta)\left(\sigma_B(s, T+\delta)-\sigma_B(s, T)\right)ds\] This equals \(\frac{\sigma^2}{a^3}\left(1-e^{-a\delta}\right)\left(1-e^{-a(T-t)}-\frac{e^{-a\delta}}{2}\left(1-e^{-2a(T-t)}\right)\right)\). \subsection{Swap} An interest rate swap is an instrument in which two parties exchange rates: typically fixed for floating. This exchange is in arrears, that is, after the time period \(\delta\) of the floating rate has passed. Letting \(B(t, T)\) be the price of a zero coupon bond at time \(t\) maturity and time \(T\), the payoff the receiver of floating is the following: \[\sum_{i=0} ^ n \frac{1-B(t_i, t_i+\delta)}{B(t_i, t_i+\delta)\delta}-k\] Where \(t_0=t\), \(t_n=T\) and \(T\) is the maturity. The price of this swap is \[\sum_{i=0}^n \mathbb{\tilde{E}}\left[D(t_0, t_i+\delta)\left(\frac{1-B(t_i, t_i+\delta)}{B(t_i, t_i+\delta)\delta}-k\right)|\mathcal{F}_{t_0}\right]\] By convention, this price is zero at the time of origination. \(k\) is termed the swap rate, and is solved by setting the equation equal to zero: \[\sum_{i=0}^n \mathbb{\tilde{E}}\left[D(t_0, t_i+\delta)\left(\frac{1-B(t_i, t_i+\delta)}{B(t_i, t_i+\delta)\delta}-k\right)|\mathcal{F}_{t_0}\right]=0\] \[\sum_{i=0}^n \mathbb{\tilde{E}}\left[\frac{D(t_0, t_i+\delta)}{B(t_i, t_i+\delta)}|\mathcal{F}_{t_0}\right]=\sum_{i=0}^n \mathbb{\tilde{E}}\left[D(t_0, t_i+\delta)\left(1+k\delta\right)|\mathcal{F}_{t_0}\right]\] \[\sum_{i=0}^n B(t_0, t_i)=\sum_{i=0}^n B(t_0, t_i+\delta)\left(1+k\delta\right)\] \[k=\frac{1}{\delta}\left(\frac{\sum_{i=0}^n B(t_0, t_i)}{\sum_{i=0}^n B(t_0, t_i+\delta)}-1\right)\] \(t_i\) is typically chosen as a multiple of \(\delta\). In this case, the swap rate can be further simplified: \[k=\frac{1}{\delta}\left(\frac{1-B(t_0, t_n+\delta)+\sum_{i=0}^n B(t_0, t_i+\delta)}{\sum_{i=0}^n B(t_0, t_i+\delta)}-1\right)\] \[=\frac{1}{\delta}\left(\frac{1-B(t_0, t_n+\delta)}{\sum_{i=0}^n B(t_0, t_i+\delta)}\right)\] \subsection{Equivalence of Option on Coupon Bond and European Swaption} A swaption is the right to enter a swap at a future date at a predetermined swap rate. This can be written as \[\mathbb{\tilde{E}} \left[D(t, T)\left(1-\sum c_j B(T, T_j) \right)^+ | \mathcal{F}_t \right]\] Where \(c_j=k\delta,\,j