Source:
Longstaff, Francis A., Schwartz, Eduardo S. A simple approach to Valuing Risky Fixed and Floating Rate Debt. Journal of
Finance. Vol 3. July 1995.
Vasicek, O. 1977 "An Equilibrium Characterization of the term structure." Journal of Financial Economics 5: 177-188.
P(X,r,T)=D(r,T)−wD ( r,T ) Q ( X ,r,T ) a: z plus constant (c) to represent market price of risk
T: time to maturity
w: writedown = 1 - recovery rate
D(r,T) is the value of riskfree (no credit risk) discount bond according to Vasicek (1977).
A (T )−B(T )r )
D(r ,T )=e
with 2 2 2
η α η α ( e−βT −1 ) − η
A ( T )= ( 2β
2− β ) (
T+
β
3−
β
2 ) ( 4β
3 )( −2 βT
e −1 )
1−e−βT
B (T )=
α
Q(X,r,T) term can be interpreted as probability - under risk neutral measure - that default occurs.
n
q1 =N ( a1 )
Q( X , r , T , n )=∑ qi i−1
i=1
qi =N ( ai )− ∑ q j N ( bij ) , i=2,3 ,. . . .. , n
j=1
N(.) denotes the cumulative standard normal distribution
with
−ln X −M (iT /n , T ) M ( jT /n , T )− M ( iT /n , T )
ai = bij =
√ S (iT /n ) √ S ( iT /n )−S ( jT /n )
α − ρση η2 σ2
M ( t , T )= ( β
− 2−
β 2
t )
ρση η2
+ 2 +
β (2β
3 exp − βT ( exp βt −1 )
( ) ( )
)
r α η2
+
( β
− 2 + 3 ( 1−exp (− βt ) )
β β )
η2
− ( 2 β3 )
exp (− βT ) ( 1−exp (− βt ) )
ρση η2
S ( T )= ( β
+ 2 + σ2 t
β )
ρση 2 η2
(
− 2 + 3
β β )( 1− exp (− βt ) )
η2
+
( )(
2 β3
1− exp (− 2 βt ) )
0.0%
0 2 Time to maturity
4 6 8 10 12
Discount Bond Prices as a function of bond tenor (time to maturity)
0 2 Time to 4maturity 6 8 10 12
Floating-rate
Coupon
Payment
Column X
r at t=0
Yield riskfree
bond
0 2 Time to maturity
4 6 8 10 12
Data Table
#VALUE! #VALUE! #VALUE!
0.01 #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
0.25 #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
0.5 #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
0.75 #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! r at t=0
1 #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! 0 7.00%
1.5 #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
2 #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
2.5 #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
3 #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
4 #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
5 #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
6 #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
7 #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
8 #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
9 #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
10 #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
List of iterations for q
1
2
5
10
20
50
100
200
500
1000
Risky Coupon Debt Model Longstaff & Schwartz 95
Notation L&S 95 Risky Coupon Bond Prices a
Rate r0 at t=0 r 4.0% 8
12.00
Maturity time (years) T 2.0 20
"Pullback" b 1.00 100 10.00
Instantaneous StDev. of short rate h 3.162%
h2 0.0010 10 8.00
a in L&S = z + constant a 0.060 60
V/K =X X 1.50 150 6.00
Writedown = 1 - Recovery Rate w 0.50 50
Volatility of asset value process s 20.00% 4.00
s2 0.0400 40
2.00
Instantaneous correl. Asset/interest rate r - 0.25 75
Iterations for Q n 10 -
0 1 2 Tim
Risky Coupon Bond
Fixed coupon 8.00% 32
Risky (clean price) #VALUE! Yield Curve Risky vs. Risk
Risky (incl. accrued interest) #VALUE!
Yield to Maturity Risky Bond #VALUE! 5%
Riskless Coupon Bond
Riskless coupon bond (sigma=0) #VALUE! 4%
Riskless (incl. accrued interest) #VALUE!
Yield to Maturity Riskless Bond #VALUE! 4%
Credit Spread (in bps) #VALUE!
3%
12 2%
10
2%
8
6 1%
4
1%
2
- 0%
0 2 Time to4maturity 6 8 10 12 0 1 2Time
Source:
Longstaff, Francis A., Schwartz, Eduardo S. A simple approach to Valuing Risky Fixed and Floating Rate Debt. Journal of
Firm asset value process:
dV =μ Vdt +σ VdZ 1
Interest rate process:
dV =μ Vdt +σ VdZ 1
dr= ( ζ−βr ) dt +η dZ 2
Value of risky discount bond:
Testing
#VALUE!
5%
#VALUE!
0 1 2 Time3to maturity
4 5 6 7 8 9 10
r at t=0
0 4.00%
YTM Risky YTM Riskless Spread
#VALUE! #VALUE!
#VALUE! #VALUE! #VALUE!
#VALUE! #VALUE! #VALUE!
#VALUE! #VALUE! #VALUE!
#VALUE! #VALUE! #VALUE!
#VALUE! #VALUE! #VALUE!
#VALUE! #VALUE! #VALUE!
#VALUE! #VALUE! #VALUE!
#VALUE! #VALUE! #VALUE!
#VALUE! #VALUE! #VALUE!
#VALUE! #VALUE! #VALUE!
#VALUE! #VALUE! #VALUE!
#VALUE! #VALUE! #VALUE!
#VALUE! #VALUE! #VALUE!
#VALUE! #VALUE! #VALUE!
#VALUE! #VALUE! #VALUE!
#VALUE! #VALUE! #VALUE!
#VALUE! #VALUE! #VALUE!
#VALUE! #VALUE! #VALUE!
Term structure in Vasicek Model
Hull L&S 95 Vasicec Term Structure
Running time t n.a. 0 9%
Rate r0 at t=0 r0 r 8.0% 16 8%
Maturity time (T) T 7 2.0 20
7%
"Pullback" a b 0.07 7
6%
Long-run equilibrium b n.a. 8.0% 80
Instanteanous StDev. of short rate s h 2.0% 20 5%
1%
Results:
0%
B in Vasicek Model (Hull) 1.87
0 5Time to10
A in Vasicek Model (Hull) 0.989838 -0.010214 0.0391837
Infinitely-long Rate (Y¥) 3.92%
Vasicek Discount Factor 0.852554 #VALUE! #VALUE!
Vasicek Zero Rate 7.976%
1−e−βT
B (T )=
β
2 2 2
η α η α η
A ( T )=
( 2β
2− β ) (
T+
β
3−
β
2 ) (e −βT
−1 ) −
( 4β
3 ) ( e−2 βT −1
2 2 2
η α η α η
A ( T )=
( 2β
2− β ) (
T+
β
3−
β
2 ) (e −βT
−1 ) −
( 4β
3 ) ( e−2 βT −1
Source:
Longstaff, Francis A., Schwartz, Eduardo S. A simple approach to Valuing Risky Fixed and Floating Rate Debt. Journal of F
Hull, John C., Options, Futures & Other Derivatives. Fourth edition (2000). Prentice-Hall. p. 567.
Model: Vasicek, O. 1977 "An Equilibrium Characterization of the term structure." Journal of Financial Economics 5: 177-18
η2 α η2 α η2
A ( T )=
( 2β
2− β ) (T+
β
3−
β
2 )( −βT
e −1 ) −
( 4β
3
σ2 c σ2 b c σ2
A ( T )=
( 2 a2
− b−
a ) (
T+
a3
−
a
−
a2
(e ) −aT
−1 ) −
( 4
Formula in Hull p. 567. The following transformations prove that A(T) is the same in Hull and L&S 95
2
σ
)( )
2
a b− 2
1− e−aT 2 σ 2 ( 1−e−aT )
A ( T )=
a ( −T
a2
−
4 a3
2 −aT −2 aT
2 a2 b−σ 2 2 a2 b−σ 2 ( σ ( 1−2 e +e )
A (T )=−
2a (
2) ( )
T+
2a 3
−aT
1−e − )
4 a3
2 −2 aT
σ2 b σ2
−aT
σ ( 1−2 e + e )
A (T )=
2 a2( ) ( )(
−b T + −
a 2 a3
1−e−aT
)−
4 a3
σ2 σ 2 b −aT σ 2 −aT σ 2 σ 2 e−aT σ 2 e−2 aT
2a ( ) ( )( )
A (T )= 2 −b T + 3 − e −1 − 3 ( e −1 )− 3 + 3 −
a a 2a 4 a 2a 4a3
σ2 σ 2 b −aT σ 2 e−aT σ 2 σ 2 σ 2 e−aT σ 2 e−2 aT
2a ( ) ( )( )
A (T )= 2 −b T + 3 − e −1 − 3 + 3 − 3 + 3 −
a a 2a 2a 4a 2a 4a3
σ2 σ 2 b −aT σ 2 −2 aT
A ( T )=
2a ( ) ( )(
2
−b T + 3 −
a a
e −1 ) + 3 ( e
4a
−2+ 1 )
Formula in L&S p. 795 with market price of risk factor.
σ2 c 2 σ2 c ( e−aT
A ( T )= ( 2a 2
−b−
a ) (
T+
2a 2
−b−
a ) a
( e−aT −1 ) σ 2 e−aT −1 σ 2
c
A ( T )= T − ( a )( 2a 2
−b−
a
+
a ) (
Infinitely long rate: σ2 λσ λσ c
Y ∞= b− 2+ ⇒ = ⇒
2a a a a
Formula for infinitely long rate with market price of risk from:
Craig Holden, Spreadsheet Modeling CD-ROM series, http://www.pr
Holden, Craig W. Holden. Spreadsheet Modeling in Investments, Pre
Vasicec Term Structure of Interest
9% Data Table
8% 0.852554
Vasicek Zero 0.001 0.99992
7% Rate 0.5 0.960797
6%
Long-term 1 0.923175
5% equilibrium
rate 2 0.852554
4% 3 0.787842
Infinitely long 4 0.728678
3% rate
5 0.674666
2% r at t=0 6 0.625399
1% 7 0.580475
8 0.539508
0%
9 0.502134
0 5Time to10maturity
15 20 25 30 35
10 0.468013
15 0.336216
20 0.249459
25 0.190067
30 0.147827
k Discount
This sheet has been added to compare the valuation of discount bonds
according the Vasicek (77) model both in the notation used by Longstaff &
Schwartz (95) and Hull in his well known derivatives textbooks (see
comment in cell A! for detailed reference)
with constants
z: long-term equilibrium of mean reverting process
b: "pull-back" factor - speed of adjustment
h: spot rate volatility
dZ2 standard Wiener process (N.B. Z1 is process for asset value)
Infinitely-long Rate (Y¥)
2
η
−
( 4β
3 ) ( e−2 βT −1 )
2
η
−
( 4β
3 ) ( e−2 βT −1 )
η2
−βT
−1 ) −
( 4β
3 ) ( e−2 βT − 1 )
σ2
(e −aT
−1 ) −
( 4a 3 ) ( e−2 aT −1 )
−aT −2 aT
2 e +e )
4 a3
−aT −2 aT
e +e )
4 a3
σ 2 e−aT σ 2 e−2 aT
3
−
2a 4a3
2 −aT
e σ 2 e−2 aT
3
−
2a 4a3
e−2 aT −2+ 1 )
c ( e−aT −1 ) σ2
−b−
a ) a
−( 4 a3 )( e−2 aT −1 )
e−aT −1 σ 2 σ2
) +
a 2a2
− ( 4a 3
e−2 aT
)(
−1 ) )(
λσ c
⇒ = ⇒c= λσ
a a
market price of risk from:
g CD-ROM series, http://www.prenhall.com/holden/
eet Modeling in Investments, Prentice Hall (2002), p.49
Long-term equilibrium rate
8.000% 0 8.00%
7.998% 30 8.00%
7.994%
7.976% r at t=0
7.949% 0 8.00%
7.913%
7.871%
7.823% Infinitely long rate
7.770% 0 3.92%
7.714% 30 3.92%
7.654%
7.593%
7.267%
6.942%
6.642%
6.372%