David BACKUS New York,NY 100121126 (dbackus@stern.nyu.edu) Stern School of Business, New YorkUniversity, Silverio FORESI Salomon BrothersInc., New York,NY 10048 Stanley ZIN PA 152133890 GraduateSchool of Industrial Administration, Carnegie MellonUniversity, Pittsburgh,
modelsof bondpricingare used by both academicsand Wall Streetpractitioners, Mathematical with practitioners to modelsto selected introducing timedependent parameters fit "arbitragefree" assetprices.We show,in a simpleonefactor a setting,thatthe abilityof suchmodelsto reproduce subsetof securitypricesneed not extendto statecontingent claimsmoregenerally. arguethat We of models shouldbe complemented close attention the additional to parameters arbitragefree by which mightincludemeanreversion, fundamentals, multiplefactors,stochasticvolatility,and/or nonnormal interestrate distributions. KEY WORDS: Fixedincome claims. derivatives; Options; Pricingkernel;Statecontingent
Since Ho and Lee (1986) initiated work on "arbitragefree" models of bond pricing, academics and practitioners have followed increasingly divergent paths. Both groups have the same objectiveto extrapolate from prices of a limited range of assets the prices of a broader class of statecontingent claims. Academics study relatively parsimonious models, whose parametersare chosen to approximate "average" or "typical"behavior of interest rates and bond prices. Practitioners, on the other hand, use models with more extensive sets of timedependent parameters, which they use to match current bond yields, and possibly other asset prices, exactly. To practitioners, the logic of this choice is clear: The parsimonious models used by academics are inadequate for practical use. The four parameters of the onefactor Vasicek (1977) and CoxIngersollRoss (1985) models, for example, can be chosen to match five points on the yield curve (the four parameters plus the short rate) but do not reproduce the complete yield curve to the degree of accuracy required by market participants. Even more general multifactor models cannot generally approximate bond yields with sufficient accuracy. Instead, practitioners rely almost universally on models in the Ho and Lee (1986) tradition, including those developed by Black, Derman, and Toy (1990), Black and Karasinski (1991), Cooley, LeRoy, and Parke (1992), Heath, Jarrow, and Morton (1992), Hull and White (1990, 1993), and many others. Although analytical approaches vary across firms and even within them, the BlackDermanToy model is currently close to an industry standard. Conversely, academics have sometimes expressed worry that the largeparameter sets of arbitragefree models may mask problems with their structure. A prominent example is Dybvig (1997), who noted that the changes in parameter values required by repeated use of this procedure contra13
dicted the presumption of the theory that the parameters are deterministic functions of time. Black and Karasinski (1991, p. 57) put it more colorfully: "When we value the option, we are assuming that its volatility is known and constant. But a minute later, we start using a new volatility. Similarly, we can value fixed income securities by assuming we know the onefactor shortrate process. A minute later, we start using a new process that is not consistent with the old one." Dybvig argued that these changes in parameter values through time implied that the framework itself was inappropriate. We examine the practitioners' procedure in a relatively simple theoretical setting, a variant of Vasicek's (1977) onefactor Gaussian interestrate model that we refer to as the benchmark theory. Our thought experiment is to apply models with timedependent drift and volatility parameters to asset prices generated by this theory. We judge the models to be useful, in this setting, if they are able to reproduce prices of a broad range of statecontingent claims. This experiment cannot tell us how well the models do in practice, but it allows us to study the role of timedependent parameters in an environment that can be characterized precisely. We find, in this environment, that, if the world exhibits mean reversion, then the use of timedependent parameters in a model without mean reversion can reproduce prices of a limited set of assets but cannot reproduce the prices of general statecontingent claims. In this sense, these arbitragefree models allow arbitrage opportunities: A trader basing prices on, say, the BlackDermanToy model can be exploited by a trader who knows the true structure of the economy.
9 1998 American Statistical Association Journal of Business & Economic Statistics January 1998, Vol. 16, No. 1
14
Considera oneperiodbond.FromEquation(5) and the initial conditionb? = 1, we see that the price is the conditionalmean of the pricingkernel:b1= Etmt+l. Because the kernelis conditionally we lognormal, needthe following of lognormal randomvariables: log x is normal If property with mean p and variancea2, then log E(x) = p + a2/2. 1. A THEORETICALFRAMEWORK From we see that log mt+l has conditional We use a onefactorGaussianinterestrate model as a mean Equation(3) and conditionalvariance(Aa)2. The oneperiod zt in procedure bond laboratory whichto examinethe practitioners' price satisfies log b1 = zt + (Aa)2/2 and the short to of choosingtimedependent parameters fit a bondpricing rate is assetprices.The modelis a close relative modelto observed of one describedby Vasicek(1977). Althoughin some rert =  log b1 = zt  (Aa)2/2. (6) its spectsit is simplerthanthoseused by practitioners, logis linear structure extremelyuseful in clarifyingthe roles Thus, the shortrate r is the state z with a shift of origin. The meanshortrate is 6  (Aa)2/2, which we denoteby p by its variousparameters. played To fix the notation,let bVbe the price at date t of a in the rest of the article. bond of maturity the claim to one dollarat n, The stochastic zerocoupon (2), processfor z, Equation impliessimilar date t + n. By conventionb  1 (one dollartoday costs behaviorfor the shortrate:
one dollar). Bond yields are y7 = n1 log bZ andforward rates are ft" = log(bt"/bn+ ). We label the short rate rt = yl f,.
rt+ = rt + (1  P)(p  rt) + Et+l,
(7)
A strikingexampleof mispricing this settinginvolves in options on long bonds. Options of this type vary across two dimensionsof time, the expirationdate of the option andthe maturity the bondon whichthe optionis written. of modelhas a onedimensional The BlackDermanToy array that can be chosen to reproduce of volatility parameters dateon oneeitherthe pricesof optionswith anyexpiration periodbonds or of optionswith commonexpirationdates on bonds of any maturity. But, if the world exhibitsmean this the reversion, vectorcannotreproduce twodimensional arrayof pricesof bondoptions.If the volatilityparameters are chosento matchpricesof optionson oneperiod bonds, then the model overpricesoptionson long bonds. Althoughwe think that mean reversionis a useful feature in a model, it illustratesa more generalpointthat of whatevertheir form, misrepresentations fundamentals, cannot generallybe overcomeby adding arraysof timeFrom this perspective,the role of dependentparameters. academicresearchis to identifyappropriate fundamentals, which might includemultiplefactors,stochasticvolatility, We movements. conjecture interestrate and/or nonnormal that arbitragefree models with inaccuracies along any of these dimensionswill mispricesome assets as a result.
(3)
The parameter which we refer to as the price of risk, A, determines covariance the betweeninnovations thekernel to andthe state and thus the risk characteristics bondsand of relatedassets. Given a pricingkernel,we deriveprices of assets from the pricingrelation 1 = Et(mt+xRt+x), (4)
which holds for the gross returnRt+l on any tradedasset. Because the oneperiodreturnon an n + 1periodbond is b 1/b"+1,the pricingrelationgives us i+
bn+1 = Et(mt+lbtn,+),
(5)
(1)
asset pricesin ourbenchmark We characterize theory,or with a pricing kernel,a stochasticprocessgovlaboratory, claims.Existenceof such erningprices of statecontingent
a process is guaranteed in any arbitragefree environment. for n _ 1, which yields conditional first and second moWe describe the kernel for our theoretical environment in ments of two steps. The first step involves an abstract state variable z, whose dynamics follow: (8) Et(rt+n) = rt + (1  (P)(p  rt)
Zt+i =
pzt + (1  p)6
+et+l
(2)
and
with {et} distributed normally and independently with mean 0 and variance a2. The parameter controls mean reversion: With = 1, the state follows a random walk, but with values between 0 and 1, the conditional mean of future values of z converges to the unconditional mean 6. Step 2 is the pricing kernel m, which satisfies
= vart(rt+n) 2
j=1
) 2(nj
2 1 2
(9)
We return to these formulas later. Prices of long bonds follow from (5); details are provided in Appendix A.1. Their properties are conveniently summarized by forward rates, which are linear functions of
15
Mean 7.483 7.915 8.190 8.372 8.563 9.012 9.253 9.405 9.524 9.716 9.802
Standarddeviation 1.828 1.797 1.894 1.918 1.958 1.986 1.990 1.983 1.979 1.956 1.864
Autocorrelation .906 .920 .926 .928 .932 .940 .943 .946 .948 .952 .950
 rt) + [A2
(A?
2/2
(10) for all n > 0. Given forwardrates, we can computebond prices and yields from their definitions.The right side of If Equation(10) has a relativelysimple interpretation. we compareit to (8), we see that the first two terms are the expectedshortraten periodsin the future.We referto the last term as a risk premiumand note that it dependson three parametersthe magnitudeof risk (a), the price of risk (A), and meanreversion(po). Both the Ho and Lee (1986) and Black, Derman,and an Toy (1990) models are capableof reproducing arbitrary forwardratecurve (equivalently, yields or bondprices),inmodel like this one. cludingone generated a theoretical by An issue we addresslateris whetherthis capability extends to more complexassets. With this in mind,considera Eudate t + 7 and ropeancall option at date t, with expiration strike price k, on a zerocouponbond with maturityn at expiration.Given the lognormalityof bond prices in this setting,the call price is given by the BlackScholes(1973) formula,
cn" = br+nN(dx)  kb[N(d2),
1 month 3 months 6 months 9 months 12 months 24 months 36 months 48 months 60 months 84 months 120 months
NOTE: Dataare monthly estimatesof annualized, U.S. compounded, continuously zerocoupon bondyieldscomputed McCulloch Kwon and is government by (1993).Thesampleperiod January 1982 to February 1992.
month.FromEquation we see thatp is the unconditional (7) meanof the shortrate,so we set it equalto the samplemean of the onemonth yield in Table1, 7.483/1,200. (The 1,200 convertsan annual rate percentage to a monthlyyield.)The meanreversion of ?o parameter is the first autocorrelation the shortrate.In Table 1 the autocorrelation .906, so we is set ?pequal to this value. This indicatesa high degree of persistencein the short rate but less than with a random walk. The volatilityparameter is the standard deviation a of innovationsto the short rate, which we estimate with the standard errorof the linearregression(7). The resultis to matchthe mean,standard deviation,and autocorrelation of the shortrate.We choose the final parameter, price the of risk A,to approximate slope of the yield curve.Note the from (10) thatmeanforwardrates,in the theory,are
E(f)
=
(11)
p+
A2
A+
a2/2.
)=
12
1
2.
(12)
See Appendix A.4. Jamshidian (1989) reported a similar formula for a continuoustime version of the Vasicek model. The primary difference from conventional applications of the BlackScholes formula is the role of the meanreversion
parameter in (12). cn
2. PARAMETERVALUES
The parametervalues used in the following numerical examples come from an informal momentmatching exercise based on properties of monthly yields for U.S. government securities computed by McCulloch and Kwon (1993). Some of the properties of these yields are reported in Table 1 for the sample period 19821991. We choose the parameters to approximate some of the salient features of bond yields using a time interval of one
we see that A = 750 produces theoretical mean yields (the line in the figure) close to their sample means (the stars) for maturities between one month and 10 years. With more negative values, the mean yield curve is steeper, and with less negative (or positive) values, the yield curve is flatter (or downward sloping). Thus we see that all four parameters are required for the theory to imitate the dynamics of interest rates and the average slope of the yield curve. We use these benchmark values later to illustrate differences in prices across bondpricing models. 3. HO AND LEE REVISITED
This tells us that to producean increasingmean forwardrate curve (implyingan increasingmean yield curve) we need A to be negative.The price of risk parameter, other in words, governsthe averageslope of the yield curve. One way of fixing A, then, is to select a value that makes the theoreticalmean yield curve similarto the sample mean yield curve, given our chosen values for the other three An parameters. exampleis picturedin Figure 1, in which
We turn now to the use of timedependent parameters to fit theoretical models to observed asset prices. We apply,
16
rt+n
rt +
Y
j=1
(at+j + rlt+j),
(16)
9
Et (rt+n)
8
Tt + Zat+j
j=1
(17)
for n > 0. If we compare this to the analogous expression for the benchmark theory, Equation (8), we see that the two are equivalent if we set
n
20
40
80 60 in Maturity Months
100
120
Z
j=1
at+,
(1  yn)(
Tt).
(18)
Figure 1. Mean Yieldsin Theoryand Data. The line is theory,the stars are data points.
in turn, analogs of the models of Ho and Lee (1986) and Black, Derman, and Toy (1990) to a world governed by the benchmark theory of Section 1. Our first example is a Gaussian analog of Ho and Lee's (1986) binomial interestrate model. The analog starts with a state equation, zt+l = zt + at+l + rlt+, (13)
Thus, the timedependent drift parameters of the Ho and Lee model can be chosen to imitate this consequence of mean reversion in the benchmark theory. In practice it is more common to use the drift parameters to fit the model to the current yield curve. To fit forward rates generated by the benchmarktheory, we need [compare (10) and (15)]
n
j=1
Zat+j
with timedependent parameters {at} and normally and independently distributed innovations {t } with mean 0 and constant variance 32. The pricing kernel is
 log mt+ = zt + 7r7t+1. (14)
1  (pn =, n lim 1 We use different letters for the parameters than in the o1 benchmark theory to indicate that they may (but need not) take on different values. Our Ho and Lee analog differs from we can equate the two expressions when ? = 1 by setting the benchmark theory in two respects. First, the shortrate 3 = a and y = A. But when 0 < p < 1 the two expressions cannot be reconciled. This is evident in Figure 2, in which process does not exhibit mean reversion, which we might think of as setting ? = 1 in Equation (2). Second, the state equation (13) includes timedependent "drift" parameters {at}. 4Given Equations (13) and (14), the pricing relation (5) Match 3 ,' ExpectedShortRates implies a short rate rt = zt  (y3)2/2 and forward rates = fZZ rt +
j= 1
(15)
for n > 1. See Appendix A.2. Note that (10) differs from (15) of the benchmark in two ways. One is the impact of the short rate on long forward rates. A unit increase in r is associated with increases in fn of 1 in Ho and Lee, but (1p") < 1 in the benchmark. The other is the risk premium, the final term in Equation (15). Despite these differences, timedependent drift parameters allow the Ho and Lee model to reproduce some of the features of the benchmark theory. One such feature is the conditional mean of future short rates. The future short
4 3
50
15
35
40
45
50
Figure 2. Two Choices of Ho and Lee DriftParameters. One matches the current bond yields. The other matches expected future short rates.
17
we graphthe two choices of cumulativedrift parameters, n estimatedin Section 2, =, at+j, using the parameters with / = a, y A, and r = 3.0/1,200. The drift parameters meanconvergerapidlyas the the thatreproduce conditional effects of meanreversion wearoff. But the driftparameters that fit the currentyield curve get steadilysmalleras they offset the impactof maturityon the risk premiumin this in model.This results,for the rangeof maturities the figure, in a decliningtermstructure expectedfutureshortrates, of whereasthe benchmark implies the reverse. The discrepancy the figurebetweenthe two choices of in driftparameters a concreteexampleof the following: is Remark1. The parameters the Ho and Lee model of can be chosento matchthe current yield curveor the conditionalmeansof futureshortrates,butthey cannotgenerally do both. Thisproperty the Ho andLee modelis a hintthattimeof drift parameters not adequatelycapturethe do dependent effects of meanreversionin the benchmark theory.Dybvig A (1997) made a similarobservation. closer look indicates thatthe difficulty in the nonlinear lies in interaction the risk betweenmeanreversionand the price of risk. In premium the benchmark theory,the risk premiumon the nperiod forwardrate [see Eq. (10)] is
A2A A+ 
120
.100
o 8
20
20
25
intuitionaboutoptionsis easily verified. BlackScholes The formula,Equation (11), appliesto the Ho andLee model if we use optionvolatility
v,n vart(1ogb,)
= T(n3)2.
(20)
2/2.
This formulacannotbe reconciledwith that of the benchmarktheory,Equation(12), for all combinations T and of the reproduce option volatilityv1,l of a short option on a shortbond,thenwe overstate volatilitiesof long options the on long bonds. As a result, the model overvaluesoptions with more distantexpirationdates and/or longer underlying bonds. We see in Figure 3 that call prices c,'1 impliedby the Ho and Lee model can be substantially higherthan those The figure expresses generatedby the benchmark theory. the mispricingas a premiumof the Ho and Lee price over the price generatedby the benchmark theory.Benchmark values of Section 2. Ho prices are based on the parameter andLee pricesarebasedon driftparameters matchcurthat rent bond prices,Equation(19), and a volatilityparameter
For = 1 the two models generate n unless p = 1. If we choose the volatility parameter 0 to
In the Ho and Lee model,Equation(15), the analogousexpression is [y2  (y + n)2]032/2. If we choose  = A and
0 = a, the two expressions are equal for n = 1, but they
move apartas n grows. The discrepancy noted in Remark 1 is a directconsequence. A similarcomparison conditional of variances shows also of strain.The conditionalvariancesof future short signs rates implied by the Ho and Lee model are vart(rt+n) = np2. If we comparethis to the analogousexpressionin the benchmark theory,Equation(9), we see thatthey generally = differ when Wp 1. With p < 1 and 0 = a, the conditionalvariances the samefor n = 1, but for longertime are horizons they are greaterin the Ho and Lee model. We 0 = a that matches the option volatility v1,1 of a oneperiod summarize discrepancy the following: this in option on a oneperiodbond. Both are evaluatedat strike
cannot be chosen to reproduce the conditional variances of future short rates.
T Remark2. The parameters the Ho and Lee model the same call of price, but for options with expirationdates
price k = b/b+n.
12 months in the future the Ho and Lee price is more than 50% higher. 4. BLACK,DERMAN,AND TOY REVISITED
Thus, we see that additional drift parameters allow the Ho and Lee model to imitate some of the effects of mean reversion on bond yields. They cannot, however, reproduce the conditional variances of the benchmark theory. Dybvig (1997) summarized this feature of the Ho and Lee model more aggressively: "[T]he Ho and Lee model starts with an unreasonable implicit assumption about innovations in interest rates, but can obtain a sensible initial yield curve by making an unreasonable assumption about expected interest rates. Unfortunately, while this ... give[s] correct pricing of discount bonds ..., there is every reason to believe that it will give incorrect pricing of interest rate options."Dybvig's
Black, Derman, and Toy (1990) extended the timedependent parametersof Ho and Lee to a second dimension. They based bond pricing on a binomial process for the logarithm of the short rate in which both drift and volatility are time dependent. We build an analog of their model that retains the linear, Gaussian structure of previous sections but includes these two sets of timedependent parameters. Given a twoparameter distribution like the normal, timedependent drift and volatility can be used to match the conditional distribution of future short rates exactly and thus
18
to mitigatethe tendencyof the Ho andLee model to over This implies conditional of variances The questionis whetherthey also allow pricelong options. us to reproduce prices of other interestratederivative the j) vart(rt+n) o=2EW2 (Xa securities. j=1 Ouranalogof the BlackDermanToy model addstimeto the structure Section3: A random the same as Equation(9) of the theory.Similarpatterns of volatility dependent of decliningtimedependent volatilitiesare commonwhen variablez follows these methodsare used in practice,Black et al.'s numeri(21) cal exampleincluded(see theirtableI). To matchthe conZt+1= Zt+ at+1 + 7?t+l, ditionalmean of the benchmark theory,Equation(8), we choose drift parameters satisfy that the pricingkernelis and
 log mt+ = Zt + yTt+1. (22)
j=1
Zat+j (1  p)(p 
rt)
2(t+l
t+n+l)/2.
(28)
Given the critical role played by volatility in pricing derivativeassets, this representsan essential advancebeft = rt + at+j + [72  ( + n)2]t2+1/2 yond Ho andLee. j=1 the Despite timedependent volatilityparameters, model the conditional moments cannotsimultaneously 2 n reproduce + + n _ j)2( o2 of the short rate and the forwardrates of the benchmark + +  )2 ;+j  t+j+l)/2 (23) n the rate that The driftparameters reproduce forward theory. j=1 are curve,Equation(10), for n > 1. Equation (23) reducesto the Ho andLee expression, Equation(15), when 3t = /3 for all t. As in the Ho in ratesdifferfromthe benchmark andLee model,forward movementson long forward both the impactof shortrate ratesand the form of the risk premium. We can use both sets of timedependent to  [T2 (y + n)2]t2+1/2 parameters assetpricesin the benchmark theory.Consider approximate n of distribution futureshortrates.The short the conditional +n ) (It+j 3 t+j+l)/2. S (29) rate follows rr+1 = rt + 2 21+ t+2)/2 + at+1 j=1 so futureshortratesare Comparing(28) and (29), we see that the two are not n in We note the differencein the fol2 (2 _o2 (24) equivalent, general. rt+n = rt2+t+ (at+j +,7t+j). 1 t+n+l )/2+ lowing: j=1 4. Remark Given volatilityparameters (27) that repromeanand varianceare Theirconditional the conditional variances futurerates,the driftpaof duce model can be chosen rametersof the BlackDermanToy + = + (25) to matchthe currentyield curve or the conditional t+n+ 1)/2 l at+j rt Et(rt+n) 72(/+1i means of futureshortrates,but they cannotgenerallydo both. j.=1 and Figure4 plots the differencebetween(29) and (28). The parametervalues are those of Section 2, with y = A,/3t+j =
n
is The new ingredient thateachrqthas timedependent varidiffersfrom the benchmark ance 3t2.This structure theory in its absenceof meanreversion(the coefficientof 1 on zt drift (the in the state equation)and in its timedependent a's) and volatility(the /'s). bond pricing as before. We show in ApWe approach pendix A.2 that the short rate is rt = log(Etmt+1) = ratesare Zt  (y3t+1)2/2 and forward
Thus we see, as Black et al. (1990, p. 33) suggested,that we can fit the firsttwo momentsof the shortrate with two of "arrays" parameters: Remark3. The parameters the BlackDermanToy of model can be chosen to reproducethe conditionalmeans and variances futureshortrates. of
those of Figure2 for the Ho andLee modelbutarenonzero j=1 nonetheless. Remark4 is reminiscentof Remark1 for the Ho and This model, in contrastto that of Ho and Lee, is able to in matchthe conditionalvariancesof the benchmark theory, Lee model.Moresurprising, our view, is thatthe Blackthat whichwe do by choosingvolatilityparameters decline DermanToymodel's ability to reproducethe conditional varianceof future short rates does not extend to option geometrically: prices. Consider Europeancall options on zerocoupon = pjlo. (27) bonds. Once more the lognormalstructureof the model =t+j
vart(rt+n) =
3t+j.
(26)
qjl
19
1.2
0 0
> .8 0
C0.60
CD
0.4
0.2
10
15
20 30 35 25 in TimeHorizon Months
40
45
50
DifferenceBetween BlackDermanToyDrift Figure4. Cumulative Bond Yieldsand Expected ParametersChosen to Matchthe Current FutureShort Rates.
means that the BlackScholes formula,Equation(11), apto plies. If we choose drift parameters fit the currentyield betweencall pricesin the model then any difference curve, and the benchmark theorymust lie in theiroptionvolatilianaties. The option volatilityfor the BlackDermanToy is log
2 =n2 y
j=1
See AppendixA.4. If we restrictourselvesto options on oneperiodbonds (so that n = 1), we can reproducethe volatilitiesof our theoreticalenvironment choosingf's by with time, the same choice that that decline geometrically of variances futureshortrates,Equareplicatesconditional tion (27). The BlackDermanToy analogcannot,however,simultaneouslyreproduceprices of options on bonds of longer If maturities. we use the geometrically decliningparameters of Equation(27), the optionvolatilityis
Vrn =
of Remark5. The parameters the BlackDermanToy model cannotreproduce pricesof call optionson bonds the for all maturities expiration and dates. The differencein option volatilities, and hence in call prices, between the two models stems from two distinct roles played by mean reversionin determiningprices of first,in the impactof long bonds.Meanreversionappears, shortrate innovationson future short rates. We see from on (9) that the impactof innovations futureshortrates,in the theory,decays geometricallywith the time horizon T. This featureis easily mimickedin the BlackDermanToy model,as we have seen,by using volatilityparameters } {IOt that decay at the same rate. The second role of mean reversion concernsthe impact of shortratemovementson model, a unit longbondprices.In the BlackDermanToy decreasein the shortrateresultsin an n unitincreasein the logarithmof the price of an nperiodbond;see Appendix A.2. In the benchmark theory,the logarithmof the bond rises by only (1 +p+..  + 9l) = (1 _")/(1price p); see AppendixA.1. This attenuation the impactof shortof rate innovationson longbond prices is a direct consequence of mean reversion.It is not, however,reproduced by choosing geometricallydeclining volatility parameters and is therefore missing from call prices generatedby the BlackDermanToyanalog. Stated somewhat differently, the BlackDermanToyanalog does not reproduce the hedge ratiosof the benchmark theory. As a practicalmatter,then, we might expect the Blackto DermanToy procedure work well in pricingoptionson shortterm instruments, includinginterestrate caps.Foroptions on long bonds,however,the model overstatesthe option volatilityandhencethe call price.A commonexample of suchaninstrument a callablebond.Thisprocedure is will overstatethe valueof the call provisionto the isgenerally and the suer,in the theoretical environment, thusunderstate value of a callablelongtermbond. The discrepancy betweenoptionprices generated the by benchmark theoryandthe BlackDermanToy analogillus150
12
n2 r2 ) "n0
CD
C100
o
+ p"n1)2
U)
This ratio is greater than 1 when 0 < p < 1 and n > 1 and implies that, when the BlackDermanToy analog prices options on short bonds correctly, it will overprice options on long bonds. We see in Figure 5 that this mispricing gets worse the longer the maturity of the bond and is greater than 150% for bonds with maturities of two years or more. As in Figure 3, benchmark prices are based on the parameters of Section 2, the drift parameters of the BlackDermanToy analog are chosen to reproduce the current yield curve, the strike price is k = bT/b+,t, and the expiration period is 7 = 6. Thus we have the following:
O 50
0o
10
15
20
25
of CallPrices Overthe Figure5. The Premium BlackDermanToy Benchmark Price. Expiration period7 is 6.
20
trates one difficultyof using models with timedependent 0.05 vector of timedependent parametersa onedimensional cannotreproduce conditional the varivolatilityparameters 0.04 ances of bond prices across the two dimensionsof matuWe rity and timetoexpiration. turn now to a second ex0.03 whose of mispricing,a class of "exotic"derivatives ample returnsdisplaydifferentsensitivitythanbonds to interestrate movements.  0.02 Consideran asset that deliversthe power 0 of the price of an nperiodbondone periodin the future.This assethas with magnifiedsensitivity 0 0.01 some of the flavorof derivatives movements madepopular BankersTrust to interestrate by of retainsthe convenient loglinearity bondpricesin our yet 0 the As framework. with options,we compare pricesimplied by the benchmark theory, 0.01, 10
0
8
6
4
10
of Prices of the Exotic Figure6. The Premium BlackDermanToy Overthe Benchmark Price.Maturity is 60. n
(A+ 01
)2c
 rt), (30)
n
Mt,t+n 
mt+j,
j=1
+ (7y3t+1)/2)+0 log t bT
+ (,y + On)2); +1/2  0(nat+l)
n

)2 2
which define nperiodahead state prices. We show in the thatthe benchmark Appendix theoryimplies discountfactors
 log Mt,t+, 3t+j)2/2]. (31)
0>1 [(n
j=1
 j)(t+j+l
Ot+j)
(y+ n  j)2(3t2j+1
n6 +
(rt  IL)
+ 1 :)A+ ?0 Et+j
j=11 Both follow from pricingrelation(4) with the appropriate andthe BlackDermanToy analogimplies pricingkernel. Suppose we choose the parametersof the Black  log Mt,t+n = n[rt + (7l3t+1)2/2] n n DermanToyanalog to match the conditionalvarianceof future short rates [Eq. (26)], the currentyield curve [Eq. + :(n  j)at+j + (7 + n j)rnt+j. and the price of risk [y = A]. Can this model re(29)], j=1 j=1 producethe prices of our exotic asset for all values of the As long as (o , 1 and a , 0, the secondexpressioncannot 0? sensitivityparameter The answeris generallyno. When to n  1, the two models generatethe same price d' for all be madeequivalent the first: values of 0, just as we saw that the two sets of cumuladrift and volatility Proposition1. The timedependent were initiallythe same (see Fig. 4 and parametersof the BlackDermanToymodel cannot be tive driftparameters the discussionfollowingRemark4). For longermaturities, chosen to reproduce stochasticdiscountfactorsof the the
benchmark theory. A proof is given in Appendix A.3. The difficulty lies in the innovations + 1 (pl
t+j
however, the prices are generally different. Figure 6 is an example with n = 60 and r = 3.00/1,200. We see that, for values of 8 outside the unit interval, the BlackDermanToy analog overprices the exotic, although the difference between models is smaller than for options on long bonds. Remark 6. The parameters of the BlackDermanToy model can be chosen to match both the current yield curve and the term structureof volatility for options on oneperiod bonds, but they cannot generally replicate the prices of more exotic derivatives.
These examples of mispricing illustrate a more general resultthe BlackDermanToy analog cannot replicate the state prices of the benchmark theory. This result is stated most clearly using stochastic discount factors,
and (7 + n  j)rlt+j. There is no choice of volatility parameters {f3t} in the BlackDermanToy analog that can replicate the nonlinear interaction of mean reversion () and the price of risk () in the benchmark theory. In short, the timedependent drift and volatility parameters of a model like the BlackDermanToy analog cannot replicate the prices of derivative assets generated by a model with mean reversion.
21
5. ARBITRAGE AND PROFIT OPPORTUNITIES In the laboratoryof the benchmark theory,the BlackDermanToyanalog systematically mispricessome assets. In this section we consider strategiesthat might be used to profitfrom tradersusing prices indicatedby the BlackDermanToymodel. One way to exploit someonetradingat BlackDermanwith someone tradingat benchToy prices is to arbitrage mark prices. If, as we have seen, a BlackDermanToy traderoverpricesoptions on long bonds relativeto those on shortbonds and a benchmark traderdoes not, then we can buy from the latterand sell to the former,thus making a riskfreeprofit.This is as clearan exampleof arbitrage as thereis. But becausesuchprice differencesare so obvious, they are unlikelyto be very common. It is less easy to exploit a BlackDermanToytrader when tradestakeplace only at pricesdictated the model. by Because BlackDermanToyprices are consistentwith a We pricingkernel,they precluderisklessarbitrage. can often devise dynamicstrategies,however,whose returnsare large relativeto their risk. One such strategyinvolvescall options on long bonds, which (again)the BlackDermanIf Toy modelgenerallyovervalues. we sell the optionto the traderat date t, and liquidateat t + 1, we might expect to makea profit.This seems particularly likely in the option's finalperiodbecausethe optionis overvalued the bonds but on which the optionis writtenare not. we Before we evaluatethis strategy, need to explainhow the BlackDermanToy trader time.A pricesassetsthrough traderusing the BlackDermanToy modelgenerallyfinds, bothin practiceandin ourtheoretical setting,thatthe timemust be reset each period. In our dependentparameters setting, suppose that the traderchooses volatility parameters at date t to fit implied volatilities from options on shortbonds. As we have seen, this leads the traderto set W2 13t+2, 3t+3,... } equal to {a, cpr, a,...}. If the pa{ft+1, then in the followrameterswere literallytime dependent, ing periodlogic dictatesthat we set {ft+2, /t+3, /t+4, ..
0.55 0.s550.5
0.45
0.4
350
300
HoLee
w250
BDT
a 200
150 
equalto {scp, p2a,V3a,... }. But if we calibrateonce more to options on oneperiodbonds, we would instead use This leads to a predictable upward jump {a,lr, pV2a, ...}. in the volatility parameters from one period to the next, as in Figure7. Similarly,the drift parameters must be adeachperiodto retainthe model'sabilityto reproduce justed the currentyield curve.These changesin parameter values time are an indication the modelis imperfectly that through imitatingthe processgeneratingstate prices,but they neverthelessimproveits performance. this sense the internal In notedby Dybvig (1997) is a symptomof uninconsistency derlyingproblemsbutnot a problemin its own right.Thus, our traderprices call optionsusing drift and volatilityparametersthat match,each period,the yield curve and the term structureof volatilities implied by options on oneperiodbonds [Eqs.(29) and (27), respectively]. Now considera strategyagainstsuch a trader sellinga of on an nperiodbondandbuyingit backone option 7period returnfrom this strategy periodlater.The gross oneperiod is
Rt+1 = c
1,n/cT
RevisedVolatility Curve
for T > 1, with the conventionthat an option at expiration has value c?'" = (b"  k)+. The profit from this strategy is not risk free, but it can be large relativeto the risk involved. In the world of the benchmark theory, the appropriate adjustment for risk is given by the pricing relation (4). We measure the mean excess riskadjusted return by a = E(mt+lRt+l)  1, using the pricing kernel m for the
',
~0.35
0.25
0.2
benchmark is to economy.This measure analogous Jensen's alphafor the capitalassetpricingmodelandis the appropriate risk adjustment this setting.For the tradingstrategy in values of Section 2, the just describedand the parameter returnsare in the neighborhood severalhundred of percent per year;see Figure8. The returnsin the figurewere computed by Monte Carlo and concern twoperiod (7 = 2) opDatein Months
tions on bondsfor maturities between1 and24 months. (n) The returnsare greaterwith 7 = 1 but decline significantly
as 7 increases. For 7 > 6, the overpricing is difficult to
22
marketparticipants. of exploit becausethe overpricing a fiveperiodoptionthe noredby all but the most sophisticated Financialprofessionalsdo not generallyrevealtheirmethfollowingperiodis almostas great. fromothersources.Onesource ods, buttheycanbe inferred AND 6. MEANREVERSION Tuckman's is bookson fixedincome (1995)book modeling. OTHERFUNDAMENTALS orientedM.B.A. studentsand was aimed at quantitatively drift We have seen thatthe timedependent andvolatility was used in SalomonBrothers'sales and tradingtraining of analogsof the Ho andLee (1986) andBlack course,yet he devotedonly fourpagesto modelswith mean parameters (1996) targeteda similar audience the (1990) modelscannotreproduce pricesof reversion.Sundaresan DermanToy a anddisregarded meanreversion altogether. Perhaps better claims generatedby a model with mean statecontingent of sourceis Bloomberg(1996), the leadingpurveyor fixedreversion.This thoughtexperimentdoes not tell us how well these modelsperformin practice,but it indicatesthat income informationservices. Calculationson Bloomberg are of derivatives terminals the "fairvalue"of interestrate are extra parameters not a solutionto all problems: They on a lognormal of the Ho andLee model,and analog with sound based need to be used in the context of a structure of for calculations "optionadjusted spreads" callablebonds fundamentals. the same model as the default(Bloomberg1996),with We focused on meanreversionbecausewe find it an ap use model, yet it is missing Black et al. (1990) and Hull andWhite (1990) availableas pealing featurein a bondpricing models. The alternatives. from the most popularbinomialinterestrate We think, however,that the central issue is not mean in of .906 reported Table 1 is not estimatedautocorrelation differentfrom 1, but a value of 1 has, in the reversionbut whether pricing modelsarbitragefree or substantially a to the fundamentals counterfactual benchmark implica notprovide good approximation theory,two apparently in firstis thatthe meanyield curve drivingbondprices.Meanreversion, this context,is simtions for bondyields. The that In declines(to minusinfinity)withmaturity. fact, ply an exampleof a fundamental cannotbe mimicked eventually drift A by timedependent andvolatilityparameters. second upwardsloping,Figure 1 beyield curvesare, on'average, exampleis multiplefactors.Workby, amongothers,Brening a typical example.A second implicationwas pointed (1979),ChenandScott(1993),Duffieand out by Gibbonsand Ramaswamy (1993) and may be more nanandSchwartz (1986),LitterSingleton(in press),Dybvig(1997),Garbade telling:With o close to 1, averageyield curvesexhibitsubmanandScheinkman (1988)clearly (1991),andStambaugh than less stantially curvature we see in the data.An example for indicatesthe benefitsof additional factorsin accounting with ? = .99 is picturedin Figure9, in which we have set = 200 to keep the theoretical10yearyield close to its the evolutionof bond prices throughtime. Longstaffand A of Schwartz of (1992) arerepresentative a growingnumber samplemean. These two implicationsillustratethe added studiesthat identify a second factorwith volatility,whose powerof combiningtimeseriesandcrosssectioninformain models overstate variationthroughtime is apparent the prices of options tion, and suggest to us that randomwalk Yet on fixedincome instruments. another exampleis the fat rate the persistenceof the shortterm of interest.For these tails in weekly interestrate changes documentedby Das reasons,we feel that mean reversionis suggestedby the diffusion(1994), who introduced jumps into the standard of properties bondprices. basedmodels.We wouldguess thatmodelsthatignoreany For similarreasons,Black and Karasinski (1991), Heath or all of these fundamentals will, as a directconsequence, (1992), and Hull and White (1990, 1993) developedways state prices. produceinaccurate models. mean reversioninto arbitragefree of introducing We argue, in short, that fundamentals matter and that is meanreversion generallyigDespitethesedevelopments, cannotgenerallybe rectified poor choice of fundamentals parameters. by judicioususe of timedependent 10 can Whether examplesof mispricing be usedto direct our in strategies realisticsettingsdependson the relative trading 9.5 of and approximamagnitudes the mispricing the inevitable models.We wouldnot be tion errorsof moreparsimonious willing, at present,to bet our salarieson our benchmark we theory.Nevertheless, thinkthe exerciseindicatesthatit is important get the fundamentals to right.In our thought 8.5 fundamentals were represented the degree by experiment, of meanreversionin the shortrate,andwe saw thata mistake in this dimensioncould lead to largepricingerrorson in some securities.The extra timedependent parameters, otherwords,are not a panacea: They allow us to reproduce accurate a subsetof assetpricesbutdo not guarantee prices securities.In for the full range of interestratederivative 120 more generalsettings,we expect a model with n arraysof 60 80 0 40 o100 o20 Maturityin Months to parameters be able to reproducethe term structureof are Mean YieldCurveWhencp = .99. The line is prices of n classes of assets, but if the fundamentals Figure9. Theoretical theory,the stars are data points. wrong,therewill be some assets that are mispriced.
23
1

in The difficulty practiceis thateventhe best fundamental to models provideonly a roughapproximation the market Thatleaves us in the underivatives. of fixedincome prices certainterritorydescribedby Black and Karasinski (1991, p. 57): "[One]approachis to search for an interest rate process generalenough that we can assume it is true and
)
Snj
6)
+j=1 1
for n > 1. Given the discountfactors,we computebond unchanging. ... While we may reach this goal, we don't Best practice,we prices from bn = EtMt,t+n [a consequence of (5)]: know enoughto use this approach today." think, is to combine currentknowledge of fundamentals c (zt  6) to with enough extra parameters make the approximation  log b= n + (1 for tradingpurposes. adequate 2 n 1A+ S n(P) a2/2. 7. FINALTHOUGHTS
j=1
We have examined the practitioners'methodology of choosing timedependentparametersto fit an arbitrary model to currentasset prices.We showed,in bondpricing a relativelysimpletheoreticalsetting,that this methodcan systematicallymispricesome assets. Like Ptolemy's geocentric model of the solar system, these models can gento erally be "tuned"to provide good approximations (in our case) pricesof a limitedset of assets,butthey may also for provideextremelypoorapproximations otherassets.As Lochoff(1993, p. 92) putit, "Evenbadmodelscanbe tuned to give good results"for simple assets.
ACKNOWLEDGMENTS
6+n(6z)
(A+
1 
2o/2,
It is conventional expressdiscountfactors,bondprices, to and forwardrates in terms of the observableshort rate r rather thanthe abstract statevariable whichis easily done z, the linearrelationbetween them. Because p = 6 given (AU)2/2, we get discountfactors
= We thank Fischer Black and the associate editor for  log Mt,t+n extensive comments;JenniferCarpenter, VladimirFinkelstein, and Bruce Tuckmanfor guidanceon industrypractice; AnthonyLynchfor pointingout an errorin an earlier this draft;andNed Eltonfor inadvertently initiating project. Backus thanksthe NationalScience Foundation finanfor bond prices cial support.Backus and Zin are ResearchAssociate and of FacultyResearchFellow,respectively, the NationalBureau of EconomicResearch.
APPENDIX: MATHEMATICAL SUMMARY
n6(+
( " )
(P
(rt  P)
A 1+ +
Et+j,
+
=
(A.1)
We derive many of the formulasused in the text. For both the benchmark theory and our analog of the Blackmodel, we derivethe stochasticdiscountfacDermanToy tors implied by the pricing kernels listed in the text and fa s tt + (1Euna)t( rt() the implied bond prices, forwardrates, and prices of call +Eoptionson discountbonds.The resultis effectivelya mathematical summary of the article. as statedin Equation(10).
A.1 Benchmark Theory We characterize bondpricing theories with stochastic discount factors A.2 Black, Derman, and Toy
A+ _1(
a2/21
Mt,t+n
n
j=1
mt+j
We approachour Gaussian analog of the BlackDermanToy model the same way, using Equations (21) and (22) to define the pricing kernel. Our analog of the Ho and Lee model is a special case with it = P for all t. The stochastic discount factors are  log Mt,t+n = nzt + E (n  j)at+j ( + n j)nt+j.
or  log Mt,t+7   Z=l log mt+j. Given the pricing kernel m of our benchmark theory [Eqs. (2) and (3)], the stochastic discount factors are
+ j=l E
24
 log b  nzt +
j=1
(n  j)at+j 
/2
j=3
Zt +
j=1
j=2
r]t+2 (7 y+1)rt+2
j=3
t+j+1)/2.
n= 1 n= 2 n= 3
77t+3.
If a = 0, the model is risklessandreplicablewith driftpaBecausethe shortrateis rt = fto = zt  (,yt+1)2/2, we can rametersalone.Alternatively, p = 1 we can replicatethe if rewritethese relationsas benchmark theory by setting y = A and rt+j = Et+j, which  log Mt,t+n = n[rt + (7yt+1)2/2] implies 3t+j = a for all j. But with a $ 0 and ?p 1, it is impossibleto choose the price of risk 7 and volatility n "n parameters { 3t+1, t+2, /it+3} to reproduce the benchmark + (n  j)at+ + E ( + n  j)r/t+j, (A.2) theory.Supposewe try to matchthe termssequentially. To j=1 j=1 match the term (n,j) = (1, 1) we need y77t+l = AEt+l, which requires 7y3t+l = A. Similarly, equivalenceof the (2, 1) terms, (7 + 1)r7t+1= (A + 1)Et+l, tells us (for log bZ= n[rt + (70t+1)2/2]
n n
+
and
n
(7 + n  j)2
j=1
+j+l)/2,
The (3, 1) termnow requires7 + 2 = A+ 1 + p, whichis inchoices when p 1. consistentwith our earlierparameter [WhenA = 0 the same conclusionholds, but the argument startswith the (2, 1) term.]Thus we see that our attempt the to reproduce discountfactorsof the benchmark theory modelhas failed. with those of the BlackDermanToy It is easy to imaginesimilarproblemswith extensionsof the model. We could, for example,let y dependon time. But for similarreasons,this onedimensional arraycannot model. the reproduce discountfactorsof the benchmark A.4 Bond Options Any streamof cash flows {ht} can be valuedby
n
ft=
= rt +
E at+3 +
j=1
[72
(7 + n)2]02/2,
Et 1
j=1
Mt,t+j ht+j
discountfactorsM. Weuse thisrelation usingthe stochastic A.3 Nonequivalenceof DiscountFactors bonds. to price European optionson zerocoupon call Considera European optionat date t with expiration the BlackOurexamplesof assets thatare mispricedby
DermanToy model indicate that BlackDermanToy cannot generally reproduce the stochastic discount factors of our benchmark theory: of Proposition 1. The parameters {7, at, 13t} the Blackmodel cannot be chosen to reproduce the DermanToy stochastic discount factors of the benchmark theory. The proof consists of comparing the two discount factors, (A.1) for the benchmark theory and (A.2) for the BlackDermanToy model. The deterministic terms of (A.1) and (A.2) are relatively simple. For, say, the first n discount factors, we can equate the conditional means of (A.1) and (A.2) by judicious choice of the n drift parameters The stochastic terms, however, cannot ... , at+n}. {at+l, generally be equated. We can represent the initial stochastic date t + 7. The option gives its owner the right to buy an nperiod bond at date t + 7 for the exercise price k, thus generating the cash flow ht+, = (b+,  k)+, where X= = max{O, x} is the nonnegative part of x. The call price is
c"
= Et[Mt,t+,(bt+,
 k)+].
(A.3)
Computing this price involves evaluating (A.3) with the appropriate discount factor and bond price. Both of our theories have lognormal discount factors and bond prices, so to evaluate (A.3) we need two properties of lognormal expectations. Let us say that log x = (log x1, log x2) is bivariate normal with mean vector puand variance matrix E. Formula 1 is = E[xil(x2  k)] exp(Cti + a1/2)N(d)
25
with /2 d'2
and optionvolatility
d  log k + 012
V2
= 012
0.2 (1(fln)~2
where N is the standard normaldistribution functionand I is an indicatorfunctionthat equals 1 if its argument is pn)2 (12r)= 20(1 0 otherwise. similarresultwas statedandproved A positive, ' "1 cp 1 _2 by Rubinstein(1976, appendix).Except for the N term, variance the logarithm the futurebond of of this is the usual expressionfor the mean of a lognormal the conditional randomvariable.Formula2 follows from 1 with a change price. The call price for the BlackDermanToy modelfollows of variables(X212 for xl): a similar route with discount factor (A.2). If we choose  k)] the model'sparameters matchbondprices,thenthe only to E[(xl22)I(x2 = exp(Apl+ 2 + a1/2 + a2/2 + a12)N(d), differencein the call formulais the optionvolatility, with
k+ + "12 02 d d #2  log
'2 2 2E j=1 2
j=
2(rj)
Whetherthis is the same as the benchmark theorydepends Our application these formulasto (A.3) uses Mt,t+, as on the choice of of volatility parameters {tM}. x1 and bn+, as X2. The difficultywith the BlackDermanToy model with For the benchmark theory,we use discountfactor (A.1) respect to pricing options in our benchmark economy is and evaluate(A.3) using the expectation formulas.To keep similarto thatwith stochasticdiscountfactors (Proposition the notationmanageable, let 1). Volatilitiesare definedover the twodimensional array indexedby the lengthr of the optionandthe maturity of n the bond on which the optionis written.This arraycannot 2/2. An A+ 1be replicatedby the onedimensional vector of volatility j=1 Now we look at the discountfactorand futurebondprice. The discountfactoris, from (A.1),
 log Mt,t+, = parameters {3tI}.
[Received October 1995. Revised January 1997.]
1+
(rt  I)
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