Short-rate model

A short-rate model, in the context of interest rate derivatives, is a mathematical model that describes the future evolution of interest rates by describing the future evolution of the short rate, usually written $r_{t}\,$.

The short rate

Under a short rate model, the stochastic state variable is taken to be the instantaneous spot rate. The short rate, $r_{t}\,$, then, is the (continuously compounded, annualized) interest rate at which an entity can borrow money for an infinitesimally short period of time from time $t$. Specifying the current short rate does not specify the entire yield curve. However no-arbitrage arguments show that, under some fairly relaxed technical conditions, if we model the evolution of $r_{t}\,$ as a stochastic process under a risk-neutral measure $Q$ then the price at time $t$ of a zero-coupon bond maturing at time $T$ with a payoff of 1 is given by

$P(t,T)=\mathbb {E} ^{Q}\left[\left.\exp {\left(-\int _{t}^{T}r_{s}\,ds\right)}\right|{\mathcal {F}}_{t}\right]$

where ${\mathcal {F}}$ is the natural filtration for the process. The interest rates implied by the zero coupon bonds form a yield curve or more precisely, a zero curve. Thus specifying a model for the short rate specifies future bond prices. This means that instantaneous forward rates are also specified by the usual formula

$f(t,T)=-{\frac {\partial }{\partial T}}\ln(P(t,T)).$

Particular short-rate models

Throughout this section $W_{t}\,$ represents a standard Brownian motion under a risk-neutral probability measure and $dW_{t}\,$ its differential. Where the model is lognormal, a variable $X_{t}\,$, is assumed to follow an Ornstein–Uhlenbeck process and $r_{t}\,$ is assumed to follow $r_{t}=\exp {X_{t}}\,$.

One-factor short-rate models

Following are the one-factor models, where a single stochastic factor – the short rate – determines the future evolution of all interest rates. Other than Rendleman–Bartter and Ho–Lee, which do not capture the mean reversion of interest rates, these models can be thought of as specific cases of Ornstein–Uhlenbeck processes. The Vasicek, Rendleman–Bartter and CIR models have only a finite number of free parameters and so it is not possible to specify these parameter values in such a way that the model coincides with observed market prices ("calibration"). This problem is overcome by allowing the parameters to vary deterministically with time. In this way, Ho-Lee and subsequent models can be calibrated to market data, meaning that these can exactly return the price of bonds comprising the yield curve. Here, the implementation is usually via a (binomial) short rate tree; see Lattice model (finance)#Interest rate derivatives.

1. Merton's model (1973) explains the short rate as $r_{t}=r_{0}+at+\sigma W_{t}^{*}$: where $W_{t}^{*}$ is a one-dimensional Brownian motion under the spot martingale measure.
2. The Vasicek model (1977) models the short rate as $dr_{t}=(\theta -\alpha r_{t})\,dt+\sigma \,dW_{t}$; it is often written $dr_{t}=a(b-r_{t})\,dt+\sigma \,dW_{t}$.
3. The Rendleman–Bartter model (1980) explains the short rate as $dr_{t}=\theta r_{t}\,dt+\sigma r_{t}\,dW_{t}$.
4. The Cox–Ingersoll–Ross model (1985) supposes $dr_{t}=(\theta -\alpha r_{t})\,dt+{\sqrt {r_{t}}}\,\sigma \,dW_{t}$, it is often written $dr_{t}=a(b-r_{t})\,dt+{\sqrt {r_{t}}}\,\sigma \,dW_{t}$. The $\sigma {\sqrt {r_{t}}}$ factor precludes (generally) the possibility of negative interest rates.
5. The Ho–Lee model (1986) models the short rate as $dr_{t}=\theta _{t}\,dt+\sigma \,dW_{t}$.
6. The Hull–White model (1990)—also called the extended Vasicek model—posits $dr_{t}=(\theta _{t}-\alpha r_{t})\,dt+\sigma _{t}\,dW_{t}$. In many presentations one or more of the parameters $\theta ,\alpha$ and $\sigma$ are not time-dependent. The model may also be applied as lognormal. Lattice-based implementation is usually trinomial.
7. The Black–Derman–Toy model (1990) has $d\ln(r)=[\theta _{t}+{\frac {\sigma '_{t}}{\sigma _{t}}}\ln(r)]dt+\sigma _{t}\,dW_{t}$ for time-dependent short rate volatility and $d\ln(r)=\theta _{t}\,dt+\sigma \,dW_{t}$ otherwise; the model is lognormal.
8. The Black–Karasinski model (1991), which is lognormal, has $d\ln(r)=[\theta _{t}-\phi _{t}\ln(r)]\,dt+\sigma _{t}\,dW_{t}$. The model may be seen as the lognormal application of Hull–White; its lattice-based implementation is similarly trinomial (binomial requiring varying time-steps).
9. The Kalotay–Williams–Fabozzi model (1993) has the short rate as $d\ln(r_{t})=\theta _{t}\,dt+\sigma \,dW_{t}$, a lognormal analogue to the Ho–Lee model, and a special case of the Black–Derman–Toy model. This approach is effectively similar to “the original Salomon Brothers model" (1987), also a lognormal variant on Ho-Lee.

Multi-factor short-rate models

Besides the above one-factor models, there are also multi-factor models of the short rate, among them the best known are the Longstaff and Schwartz two factor model and the Chen three factor model (also called "stochastic mean and stochastic volatility model"). Note that for the purposes of risk management, "to create realistic interest rate simulations," these Multi-factor short-rate models are sometimes preferred over One-factor models, as they produce scenarios which are, in general, better "consistent with actual yield curve movements".

1. The Longstaff–Schwartz model (1992) supposes the short rate dynamics are given by: $dX_{t}=(a_{t}-bX_{t})\,dt+{\sqrt {X_{t}}}\,c_{t}\,dW_{1t}$, $dY_{t}=(d_{t}-eY_{t})\,dt+{\sqrt {Y_{t}}}\,f_{t}\,dW_{2t}$, where the short rate is defined as $dr_{t}=(\mu X+\theta Y)dt+\sigma _{t}{\sqrt {Y}}dW_{3t}$.
2. The Chen model (1996) which has a stochastic mean and volatility of the short rate, is given by : $dr_{t}=(\theta _{t}-\alpha _{t})\,dt+{\sqrt {r_{t}}}\,\sigma _{t}\,dW_{t}$, $d\alpha _{t}=(\zeta _{t}-\alpha _{t})\,dt+{\sqrt {\alpha _{t}}}\,\sigma _{t}\,dW_{t}$, $d\sigma _{t}=(\beta _{t}-\sigma _{t})\,dt+{\sqrt {\sigma _{t}}}\,\eta _{t}\,dW_{t}$.

Other interest rate models

The other major framework for interest rate modelling is the Heath–Jarrow–Morton framework (HJM). Unlike the short rate models described above, this class of models is generally non-Markovian. This makes general HJM models computationally intractable for most purposes. The great advantage of HJM models is that they give an analytical description of the entire yield curve, rather than just the short rate. For some purposes (e.g., valuation of mortgage backed securities), this can be a big simplification. The Cox–Ingersoll–Ross and Hull–White models in one or more dimensions can both be straightforwardly expressed in the HJM framework. Other short rate models do not have any simple dual HJM representation.

The HJM framework with multiple sources of randomness, including as it does the Brace–Gatarek–Musiela model and market models, is often preferred for models of higher dimension.

Further reading

• Martin Baxter and Andrew Rennie (1996). Financial Calculus. Cambridge University Press. ISBN 978-0-521-55289-9.
• Damiano Brigo, Fabio Mercurio (2001). Interest Rate Models – Theory and Practice with Smile, Inflation and Credit (2nd ed. 2006 ed.). Springer Verlag. ISBN 978-3-540-22149-4.
• Gerald Buetow and James Sochacki (2001). Term-Structure Models Using Binomial Trees. The Research Foundation of AIMR (CFA Institute). ISBN 978-0-943205-53-3.
• Andrew J.G. Cairns (2004). Interest Rate Models – An Introduction. Princeton University Press. ISBN 0-691-11894-9.
• Andrew J.G. Cairns (2004). Interest-Rate Models; entry in Encyclopaedia of Actuarial Science. John Wiley and Sons. 2004. ISBN 0-470-84676-3. {{cite book}}: External link in |title= (help)
• K. C. Chan, G. Andrew Karolyi, Francis Longstaff, and Anthony Sanders (1992). An Empirical Comparison of Alternative Models of the Short-Term Interest Rate. The Journal of Finance, Vol. XLVII, No. 3 July 1992. {{cite book}}: External link in |title= (help)CS1 maint: multiple names: authors list (link)
• Lin Chen (1996). Interest Rate Dynamics, Derivatives Pricing, and Risk Management. Springer. ISBN 3-540-60814-1.
• Rajna Gibson, François-Serge Lhabitant and Denis Talay (1999). Modeling the Term Structure of Interest Rates: An overview. The Journal of Risk, 1(3): 37–62, 1999.
• Lane Hughston (2003). The Past, Present and Future of Term Structure Modelling; entry in Peter Field (2003). Modern Risk Management. Risk Books. ISBN 9781906348304.
• Jessica James and Nick Webber (2000). Interest Rate Modelling. Wiley Finance. ISBN 0-471-97523-0.
• Robert Jarrow (2002). Modelling Fixed Income Securities and Interest Rate Options (2nd ed.). Stanford Economics and Finance. ISBN 0-8047-4438-6.
• Robert Jarrow (2009). The Term Structure of Interest Rates. Annual Review of Financial Economics, 2009, vol. 1, issue 1, pages 69-96. {{cite book}}: External link in |title= (help)
• F.C. Park (2004). "Implementing Interest Rate Models: a Practical Guide" (PDF). CMPR Research Publication.
• Riccardo Rebonato (2002). Modern Pricing of Interest-Rate Derivatives. Princeton University Press. ISBN 0-691-08973-6.
• Riccardo Rebonato (2003). "Term-Structure Models: a Review" (PDF). Royal Bank of Scotland Quantitative Research Centre Working Paper.