Pricing Zero-Coupon Bonds Under Stochastic Rates

February 29, 2012 15:49 World Scientic Book - 9in x 6in mainprivault
Chapter 4
Pricing of Zero-Coupon Bonds
In this chapter we describe the basics of bond pricing in the absence of
arbitrage opportunities. Explicit calculations are carried out for the Vasicek
model, using both the probabilistic and PDE approaches. The denition
of zero-coupon bounds will be used in Chapter 5 in order to construct the
forward rate processes.
4.1 Denition and Basic Properties
A zero-coupon bond is a contract priced P
0
(t, T) at time t < T to deliver
P
0
(T, T) = $1 at time T. The computation of the arbitrage price P
0
(t, T)
of a zero-coupon bond based on an underlying short term interest rate pro-
cess (r
t
)
tR
+
is a basic and important issue in interest rate modeling.
We may distinguish three dierent situations:
a) The short rate is a deterministic constant r > 0.
In this case, P
0
(t, T) should satisfy the equation
e
r(Tt)
P
0
(t, T) = P
0
(T, T) = 1,
which leads to
P
0
(t, T) = e
r(Tt)
, 0 t T.
b) The short rate is a time-dependent and deterministic function (r
t
)
tR
+
.
In this case, an argument similar to the above shows that
P
0
(t, T) = e
T
t
r
s
ds
, 0 t T. (4.1)
39
40 An Elementary Introduction to Stochastic Interest Rate Modeling
c) The short rate is a stochastic process (r
t
)
tR
+
.
In this case, formula (4.1) no longer makes sense because the price
P
0
(t, T), being set at time t, can depend only on information known up
to time t. This is in contradiction with (4.1) in which P
0
(t, T) depends
on the future values of r
s
for s [t, T].
In the remaining of this chapter we focus on the stochastic case (c). The
pricing of the bond P
0
(t, T) will follow the following steps, previously used
in the case of Black-Scholes pricing.
Pricing bonds with non-zero coupon is not dicult in the case of a deter-
ministic continuous-time coupon yield at rate c > 0. In this case the price
P
c
(t, T) of the coupon bound is given by
P
c
(t, T) = e
c(Tt)
P
0
(t, T), 0 t T.
In the sequel we will only consider zero-coupon bonds, and let P(t, T) =
P
0
(t, T), 0 t T.
4.2 Absence of Arbitrage and the Markov Property
Given previous experience with Black-Scholes pricing in Proposition 2.2, it
seems natural to write P(t, T) as a conditional expectation under a mar-
tingale measure. On the other hand and with respect to point (c) above,
the use of conditional expectation appears natural in this framework since
it can help us lter out the future information past time t contained in
(4.1). Thus we postulate that
P(t, T) = IE
Q
_
e
T
t
r
s
ds
F
t
_
(4.2)
under some martingale (also called risk-neutral) measure Q yet to be de-
termined. Expression (4.2) makes sense as the best possible estimate of
the future quantity e
T
t
r
s
ds
given information known up to time t.
Assume from now on that the underlying short rate process is solution to
the stochastic dierential equation
dr
t
= (t, r
t
)dt +(t, r
t
)dB
t
(4.3)
Pricing of Zero-Coupon Bonds 41
where (B
t
)
tR
+
is a standard Brownian motion under P. Recall that for
example in the Vasicek model we have
(t, x) = a bx and (t, x) = .
Consider a probability measure Q equivalent to P and given by its density
dQ
dP
= e
0
K
s
dB
s
1
2
0
|K
s
|
2
ds
where (K
s
)
sR
+
is an adapted process satisfying the Novikov integrability
condition (2.9). By the Girsanov Theorem 2.1 it is known that
B
t
:= B
t
+
_
t
0
K
s
ds
is a standard Brownian motion under Q, thus (4.3) can be rewritten as
dr
t
= (t, r
t
)dt +(t, r
t
)d

B
t
where
(t, r
t
) := (t, r
t
) (t, r
t
)K
t
.
The process K
t
, which is called the market price of risk, needs to be
specied, usually via statistical estimation based on market data.
In the sequel we will assume for simplicity that K
t
= 0; in other terms we
assume that P is the martingale measure used by the market.
The Markov property states that the future after time t of a Markov process
(X
s
)
sR
+
depends only on its present state t and not on the whole history
of the process up to time t. It can be stated as follows using conditional
expectations:
IE[f(X
t
1
, . . . , X
t
n
) | F
t
] = IE[f(X
t
1
, . . . , X
t
n
) | X
t
]
for all times t
1
, . . . , t
n
greater than t and all suciently integrable function
f on R
n
, see Appendix A for details.
We will make use of the following fundamental property, cf e.g. Theorem V-
32 of [Protter (2005)].
Property 4.1. All solutions of stochastic dierential equations such as
(4.3) have the Markov property.
As a consequence, the arbitrage price P(t, T) satises
P(t, T) = IE
Q
_
e
T
t
r
s
ds
F
t
_
= IE
Q
_
e
T
t
r
s
ds
r
t
_
,
and depends on r
t
only instead of depending on all information available
in F
t
up to time t. As such, it becomes a function F(t, r
t
) of r
t
:
P(t, T) = F(t, r
t
),
meaning that the pricing problem can now be formulated as a search for
the function F(t, x).
4.3 Absence of Arbitrage and the Martingale Property
Our goal is now to apply Itos calculus to F(t, r
t
) = P(t, T) in order to
derive a PDE satised by F(t, x). From Itos formula Theorem 1.8 we have
d
_
e
t
0
r
s
ds
P(t, T)
_
= r
t
e
t
0
r
s
ds
P(t, T)dt +e
t
0
r
s
ds
dP(t, T)
= r
t
e
t
0
r
s
ds
F(t, r
t
)dt +e
t
0
r
s
ds
dF(t, r
t
)
= r
t
e
t
0
r
s
ds
F(t, r
t
)dt +e
t
0
r
s
ds
F
x
(t, r
t
)( (t, r
t
)dt +(t, r
t
)d

B
t
)
+e
t
0
r
s
ds
_
1
2
2
(t, r
t
)
2
F
x
2
(t, r
t
)dt +
F
t
(t, r
t
)dt
_
= e
t
0
r
s
ds
(t, r
t
)
F
x
(t, r
t
)d

B
t
+e
t
0
r
s
ds
_
r
t
F(t, r
t
) + (t, r
t
)
F
x
(t, r
t
)
+
1
2
2
(t, r
t
)
2
F
x
2
(t, r
t
) +
F
t
(t, r
t
)
_
dt. (4.4)
Next, notice that we have
e
t
0
r
s
ds
P(t, T) = e
t
0
r
s
ds
IE
Q
_
e
T
t
r
s
ds
F
t
_
= IE
Q
_
e
t
0
r
s
ds
e
T
t
r
s
ds
F
t
_
= IE
Q
_
e
T
0
r
s
ds
F
t
_
hence
t e
t
0
r
s
ds
P(t, T)
is a martingale (see Appendix A) since for any 0 < u < t we have:
IE
Q
_
e
t
0
r
s
ds
P(t, T)
F
u
_
= IE
Q
_
IE
Q
_
e
T
0
r
s
ds
F
t
_
F
u
_
= IE
Q
_
e
T
0
r
s
ds
F
u
_
= IE
Q
_
e
u
0
r
s
ds
e
T
u
r
s
ds
F
u
_
= e
u
0
r
s
ds
IE
Q
_
e
T
u
r
s
ds
F
u
_
= e
u
0
r
s
ds
P(u, T).
As a consequence, (cf. again Corollary 1, p. 72 of [Protter (2005)]), the
above expression (4.4) of
d
_
e
t
0
r
s
ds
P(t, T)
_
should contain terms in d

B
t
only, meaning that all terms in dt should vanish
inside (4.4). This leads to the identity
r
t
F(t, r
t
) + (t, r
t
)
F
x
(t, r
t
) +
1
2
2
(t, r
t
)
2
F
x
2
(t, r
t
) +
F
t
(t, r
t
) = 0,
which can be rewritten as in the next proposition.
Proposition 4.1. The bond pricing PDE for P(t, T) = F(t, r
t
) is written
as
xF(t, x) = (t, x)
F
x
(t, x) +
1
2
2
(t, x)
2
F
x
2
(t, x) +
F
t
(t, x), (4.5)
subject to the terminal condition
F(T, x) = 1. (4.6)
Condition (4.6) is due to the fact that P(T, T) = $1. On the other hand,
_
e
t
0
r
s
ds
P(t, T)
_
t[0,T]
and (P(t, T))
t[0,T]
respectively satisfy the stochastic dierential equations
d
_
e
t
0
r
s
ds
P(t, T)
_
= e
t
0
r
s
ds
(t, r
t
)
F
x
(t, r
t
)d

B
t
and
dP(t, T) = P(t, T)r
t
dt +(t, r
t
)
F
x
(t, r
t
)d

B
t
,
i.e.
dP(t, T)
P(t, T)
= r
t
dt +
(t, r
t
)
P(t, T)
F
x
(t, r
t
)d

B
t
= r
t
dt +(t, r
t
)
log F
x
(t, r
t
)d

B
t
.
March 15, 2012 14:42 World Scientic Book - 9in x 6in mainprivault
4.4 PDE Solution: Probabilistic Method
Our goal is now to solve the PDE (4.5) by direct computation of the con-
ditional expectation
P(t, T) = IE
Q
T
t
r
s
ds
F
t
. (4.7)
We will assume that the short rate (r
t
)
tR
+
has the expression
r
t
= g(t) +
t
0
h(t, s)dB
s
,
where g(t) and h(t, s) are deterministic functions, which is the case in par-
ticular in the [Vasicek (1977)] model. Letting u t = max(u, t), using the
fact that Wiener integrals are Gaussian random variables (Proposition 1.3),
and the Gaussian characteristic function (12.2) and Property (a) of condi-
tional expectations, cf. Appendix A, we have
P(t, T) = IE
Q
T
t
r
s
ds
F
t
= IE
Q
T
t
(g(s)+
s
0
h(s,u)dB
u
)ds
F
t
= e
T
t
g(s)ds
IE
Q
T
t
s
0
h(s,u)dB
u
ds
F
t
= e
T
t
g(s)ds
IE
Q
T
0
T
ut
h(s,u)dsdB
u
F
t
= e
T
t
g(s)ds
e
t
0
T
ut
h(s,u)dsdB
u
IE
Q
T
t
T
ut
h(s,u)dsdB
u
F
t
= e
T
t
g(s)ds
e
t
0
T
t
h(s,u)dsdB
u
IE
Q
T
t
T
u
h(s,u)dsdB
u
F
t
= e
T
t
g(s)ds
e
t
0
T
t
h(s,u)dsdB
u
IE
Q
T
t
T
u
h(s,u)dsdB
u
= e
T
t
g(s)ds
e
t
0
T
t
h(s,u)dsdB
u
e
1
2
T
t
(
T
u
h(s,u)ds
)
2
du
.
Recall that in the [Vasicek (1977)] model, i.e. when the short rate process
is solution of
dr
t
= (a br
t
)dt + dB
t
,
and the market price of risk is K
t
= 0, we have the explicit solution, cf.
Exercise 1.3 and Exercise 3.1:
r
t
= r
0
e
bt
+
a
b
(1 e
bt
) +
t
0
e
b(ts)
dB
s
, (4.8)
hence the above calculation yields
P(t, T) = IE
Q
T
t
r
s
ds
F
t
= e
T
t
(r
0
e
bs
+
a
b
(1e
bs
))ds
e
t
0
T
t
e
b(su)
dsdB
u
e
2
2
T
t
(
T
u
e
b(su)
ds
)
2
du
= e
T
t
(r
0
e
bs
+
a
b
(1e
bs
))ds
e
b
(1e
b(Tt)
)
t
0
e
b(tu)
dB
u
e
2
2
T
t
e
2bu
e
bu
e
bT
b
2
du
= e
r
t
b
(1e
b(Tt)
)+
1
b
(1e
b(Tt)
)(r
0
e
bt
+
a
b
(1e
bt
))
e
T
t
(r
0
e
bs
+
a
b
(1e
bs
))ds+
2
2
T
t
e
2bu
e
bu
e
bT
b
2
du
= e
C(Tt)r
t
+A(Tt)
,
where
C(T t) =
1
b
(1 e
b(Tt)
),
and
A(T t) =
1
b
(1 e
b(Tt)
)(r
0
e
bt
+
a
b
(1 e
bt
))
T
t
(r
0
e
bs
+
a
b
(1 e
bs
))ds
+
2
2
T
t
e
2bu
e
bu
e
bT
b
2
du
=
1
b
(1 e
b(Tt)
)(r
0
e
bt
+
a
b
(1 e
bt
))
r
0
b
(e
bt
e
bT
)
a
b
(T t) +
a
b
2
(e
bt
e
bT
)
+

2
2b
2
T
t
1 + e
2b(Tu)
2e
b(Tu)
du
=
a
b
2
(1 e
b(Tt)
)(1 e
bt
)
a
b
(T t) +
a
b
2
(e
bt
e
bT
)
+

2
2b
2
(T t) +

2
2b
2
e
2bT
T
t
e
2bu
du

2
b
2
e
bT
T
t
e
bu
du
=
a
b
2
(1 e
b(Tt)
) +

2
2ab
2b
2
(T t)
+

2
4b
3
(1 e
2b(Tt)
)

2
b
3
(1 e
b(Tt)
)
=
4ab 3
2
4b
3
+

2
2ab
2b
2
(T t)
+
2
ab
b
3
e
b(Tt)

2
4b
3
e
2b(Tt)
.
See Exercise 4.5 for another way to calculate P(t, T) in the [Vasicek (1977)]
model.
Note that more generally, all ane short rate models as dened in Rela-
tion (3.1), including the Vasicek model, will yield a bond pricing formula
of the form
P(t, T) = e
A(Tt)+C(Tt)r
t
,
cf. e.g. 3.2.4. of [Brigo and Mercurio (2006)].
4.5 PDE Solution: Analytical Method
In this section we still assume that the underlying short rate process is
the Vasicek process solution of (4.3). In order to solve the PDE (4.5)
analytically we look for a solution of the form
F(t, x) = e
A(Tt)+xC(Tt)
, (4.9)
where A and C are functions to be determined under the conditions A(0) =
0 and C(0) = 0. Plugging (4.9) into the PDE (4.5) yields the system of
Riccati and linear dierential equations
(s) = aC(s)

2
2
C
2
(s)
C
(s) = bC(s) + 1,
which can be solved to recover
A(s) =
4ab 3
2
4b
3
+ s
2
2ab
2b
2
+

2
ab
b
3
e
bs

2
4b
3
e
2bs
and
C(s) =
1
b
(1 e
bs
).
As a verication we easily check that C(s) and A(s) given above do satisfy
bC(s) + 1 = e
bs
= C
(s),
and
aC(s) +

2
C
2
(s)
2
=
a
b
(1 e
bs
) +

2
2b
2
(1 e
bs
)
2
=

2
2ab
2b
2

2
ab
b
2
e
bs
+

2
2b
2
e
2bs
= A
(s).
-0.5
0
0.5
1
1.5
2
0 5 10 15 20
Fig. 4.1 Graph of t B
t
.
4.6 Numerical Simulations
Given the Brownian path represented in Figure 4.1, Figure 4.2 presents the
corresponding random simulation of t r
t
in the Vasicek model with
r
0
= a/b = 5%, i.e. the reverting property of the process is with respect to
its initial value r
0
= 5%. Note that the interest rate in Figure 4.2 becomes
negative for a short period of time, which is unusual for interest rates but
may nevertheless happen [Bass (October 7, 2007)].
-0.02
0
0.02
0.04
0.06
0.08
0.1
0.12
0 5 10 15 20
Fig. 4.2 Graph of t r
t
.
Figure 4.3 presents a random simulation of t P(t, T) in the same Va-
sicek model. The graph of the corresponding deterministic bond price ob-
tained for a = b = = 0 is also shown on the same Figure 4.3.
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
0 5 10 15 20
Fig. 4.3 Graphs of t P(t, T) and t e
r
0
(Tt)
.
Figure 4.4 presents a random simulation of t P(t, T) for a coupon bond
with price P
c
(t, T) = e
c(Tt)
P(t, T), 0 t T.
100.00
102.00
104.00
106.00
108.00
0 5 10 15 20
Fig. 4.4 Graph of t P(t, T) for a bond with a 2.3% coupon.
Finally we consider the graphs of the functions A and C in Figures 4.5 and
4.6 respectively.
-0.9
-0.8
-0.7
-0.6
-0.5
-0.4
-0.3
-0.2
-0.1
0
0 5 10 15 20
Fig. 4.5 Graph of t A(T t).
-2
-1.8
-1.6
-1.4
-1.2
-1
-0.8
-0.6
-0.4
-0.2
0
0 5 10 15 20
Fig. 4.6 Graph of t C(T t).
The solution of the pricing PDE, which can be useful for calibration pur-
poses, is represented in Figure 4.7.
0 0.2 0.4 0.6 0.8 1
0
0.02
0.04
0.06
0.08
0.1
0.9
0.91
0.92
0.93
0.94
0.95
0.96
0.97
0.98
0.99
1
t
x
Fig. 4.7 Graph of (x, t) exp(A(T t) +xC(T t)).
4.7 Exercises
Exercise 4.1. Consider a short term interest rate process (r
t
)
tR
+
in a
Ho-Lee model with constant coecients:
dr
t
= dt +dW
t
,
and let P(t, T) will denote the arbitrage price of a zero-coupon bond in this
model:
P(t, T) = IE
P
_
exp
_
_
T
t
r
s
ds
_
F
t
_
, 0 t T. (4.10)
(1) State the bond pricing PDE satised by the function F(t, x) dened
via
F(t, x) = IE
P
_
exp
_
_
T
t
r
s
ds
_
r
t
= x
_
, 0 t T.
(2) Compute the arbitrage price F(t, r
t
) = P(t, T) from its expression
(4.10) as a conditional expectation.
(3) Check that the function F(t, x) computed in Question (2) does satisfy
the PDE derived in Question (1).
Exercise 4.2. (Exercise 3.2 continued). Write down the bond pricing PDE
for the function
F(t, x) = E
_
e
T
t
r
s
ds
r
t
= x
_
and show that in case = 0 the corresponding bond price P(t, T) equals
P(t, T) = e
B(Tt)r
t
, 0 t T,
where
B(x) =
2(e
x
1)
2 + ( +)(e
x
1)
,
with =
_
2
+ 2
2
.
Exercise 4.3. Let (r
t
)
tR
+
denote a short term interest rate process. For
any T > 0, let P(t, T) denote the price at time t [0, T] of a zero coupon
bond dened by the stochastic dierential equation
dP(t, T)
P(t, T)
= r
t
dt +
T
t
dB
t
, 0 t T, (4.11)
under the terminal condition P(T, T) = 1, where (
T
t
)
t[0,T]
is an adapted
process. Let the forward measure P
T
be dened by
IE
_
dP
T
dP
F
t
_
=
P(t, T)
P(0, T)
e
t
0
r
s
ds
, 0 t T.
Recall that
B
T
t
:= B
t
_
t
0
T
s
ds, 0 t T,
is a standard Brownian motion under P
T
.
(1) Solve the stochastic dierential equation (4.11).
(2) Derive the stochastic dierential equation satised by the discounted
bond price process
t e
t
0
r
s
ds
P(t, T), 0 t T,
and show that it is a martingale.
(3) Show that
IE
_
e
T
0
r
s
ds
F
t
_
= e
t
0
r
s
ds
P(t, T), 0 t T.
(4) Show that
P(t, T) = IE
_
e
T
t
r
s
ds
F
t
_
, 0 t T.
(5) Compute P(t, S)/P(t, T), 0 t T, show that it is a martingale under
P
T
and that
P(T, S) =
P(t, S)
P(t, T)
exp
_
_
T
t
(
S
s

T
s
)dB
T
s

1
2
_
T
t
(
S
s

T
s
)
2
ds
_
.
Exercise 4.4. (Exercise 1.8 continued). Assume that the price P(t, T) of a
zero coupon bond is modeled as
P(t, T) = e
(Tt)+X
T
t
, t [0, T],
where > 0. Show that the terminal condition P(T, T) = 1 is satised.
Problem 4.5. Consider the stochastic dierential equation
_
_
_
dX
t
= bX
t
dt +dB
t
, t > 0,
X
0
= 0,
(4.12)
where b and are positive parameters and (B
t
)
tR
+
is a standard Brownian
motion under P, generating the ltration (F
t
)
tR
+
. Let the short term
interest rate process (r
t
)
tR
+
be given by
r
t
= r +X
t
, t R
+
,
where r > 0 is a given constant. Recall that from the Markov property, the
arbitrage price
P(t, T) = IE
P
_
exp
_
_
T
t
r
s
ds
_
F
t
_
, 0 t T,
of a zero-coupon bond is a function F(t, X
t
) = P(t, T) of t and X
t
.
(1) Using Itos calculus, derive the PDE satised by the function (t, x)
F(t, x).
(2) Solve the stochastic dierential equation (4.12).
(3) Show that
_
t
0
X
s
ds =
b
__
t
0
(e
b(ts)
1)dB
s
_
, t > 0.
(4) Show that for all 0 t T,
_
T
t
X
s
ds =
b
_
_
t
0
(e
b(Ts)
e
b(ts)
)dB
s
+
_
T
t
(e
b(Ts)
1)dB
s
_
.
(5) Show that
IE
_
_
T
t
X
s
ds
F
t
_
=
b
_
t
0
(e
b(Ts)
e
b(ts)
)dB
s
.
(6) Show that
IE
_
_
T
t
X
s
ds
F
t
_
=
X
t
b
(1 e
b(Tt)
).
(7) Show that
Var
_
_
T
t
X
s
ds
F
t
_
=

2
b
2
_
T
t
(e
b(Ts)
1)
2
ds.
(8) What is the distribution of
_
T
t
X
s
ds given F
t
?
(9) Compute the arbitrage price P(t, T) from its expression (4.10) as a
conditional expectation and show that
P(t, T) = e
A(t,T)r(Tt)+X
t
C(t,T)
,
where C(t, T) = (e
b(Tt)
1)/b and
A(t, T) =

2
2b
2
_
T
t
(e
b(Ts)
1)
2
ds.
(10) Check explicitly that the function F(t, x) = e
A(t,T)+r(Tt)+xC(t,T)
computed in Question (9) does solve the PDE derived in Question (1).

Pricing Zero-Coupon Bonds Under Stochastic Rates

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February 29, 2012 15:49 World Scientic Book - 9in x 6in mainprivault

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