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Lecture 6
6-2
1. Use of Models
Valuation of new structures
{ approach 1: look at comparable assets in the market
{ approach 2: models guarantee consistency with other
6-3
6-4
6-5
3. Vasicek Revisited
The model
, log m +1 = 2=2 + z + " +1
z +1 = (1 , ') + 'z + " +1
t
Pricing relation:
b +1 = E (m +1b +1)
n
Solution is log-linear:
, log b = A + B z
n
with
Forward rates
{ denition is
f = log(b =b +1)
{ Vasicek solution is
f = ' z + constant
n
6-6
4. Stochastic Volatility
Cox-Ingersoll-Ross model
, log m +1 = (1 + 2=2)z + z 1 2" +1
z +1 = (1 , ') + 'z + z 1 2" +1
=
Comments:
{ conditional variance varies with z : Var z +1 = 2z
{ square root keeps z positive
{ mean reversion
t
with
A +1 = A + B (1 , ') , ( + B )2 =2
B +1 = 1 + 2=2 + B ' , ( + B )2=2
(start with A0 = B0 = 0)
n
6-7
1 = E (m +1 R +1)
X ,1
log R +1 = r , (f +1
,f )
t
=1
nt
nt
nt
jt
jt
nt
nt
6-8
nt
nt
nt
Calibration
{ inputs:
current forward rates: ff g
volatility matrix: f g
{ drift parameters f g chosen to satisfy arbitrage relation
{ open question: set = 0? (more shortly)
n
t
nt
n;t
nt
Implementation on trees
6-9
Gram-Charlier smiles
6-10
7. Multi-Factor Models
Problems with one-factor models
{ changes in rates of all maturities tied to a single random
variable (")
{ shifts in spot rate curve come in only one type (parallel?)
{ correlation of spot rates across maturities restricted
{ spreads typically not variable enough
{ the model:
, log m +1 = + X(2=2 + z + "
t
it
+1
i;t
{ solution includes
= 'z + "
i
it
+1 )
j;t
+1
i;t
!2
X4 2
X
1
,
'
1
f = + 2 , + 1,' 5+ ' z :
{ standard solution: '1 close to one, '2 smaller )
z1 generates almost parallel shifts, z2 \twists"
long rates dominated by z1, spreads by z2
{ generates better behavior of spreads
n
i
it
6-11
p = q c +q c
{ one-period discount factor is b = q + q = exp(,rh)
u
Risk-neutral probabilities
{ dene = q =(q + q ), = q =(q + q )
{ note: ( ; ) are positive and sum to one
u
(they're probabilities!)
{ valuation follows
p = exp(,rh)( c + c )
u
Pricing kernel
{ dene q = m , q = m (\true probabilities")
{ valuation follows
u
p = m c + m c
u
6-12
with
Is = 0 a mistake?
6-13
Summary
1. Models are
simplications of reality
ways to ensure consistency of pricing across assets
only as good s (and
oors) and swaptions
2. Binomial models capture some of the elements of observed asset
prices, but most versions leave some issues open:
stochastic volatility
volatility smiles (again, more work)
multiple factors (possible, just more work)
can we ignore ?
3. Modeling remains as much art as science