# Arvid Kjellberg- Jakub Lawik - Juan Mojica - Xiaodong Xu

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Arvid Kjellberg- Jakub Lawik - Juan Mojica - Xiaodong Xu Slide 2 by Journal of Derivatives in Fall 1994 Where to use it? if there is a function x = f(r) of the short rate r that follows a mean reverting arithmetic process Our project: Hull and White trinomial tree building procedure Excel Implementation Slide 3 Short Rate (or instantaneous rate) The interest rate charged (usually in some particular market) for short term loans. Bonds, option & derivative prices can depend only on the process followed by r (in risk neutral world) t - t+t investor earn on average r(t) t Payoff: Slide 4 Short rate And we define the price at time t of zero-coupon bond that pays off \$1at time T by: If R (t,T) is the continuously compounded interest rate at time t for a term of T-t: Combine these formulas above: This equation enables the term structure of interest rates at any given time to be obtained from the value of r at that time and risk-neutral process for r. And we define the price at time t of zero-coupon bond that pays off \$1at time T by: This equation enables the term structure of interest rates at any given time to be obtained from the value of r at that time and risk-neutral process for r. Slide 5 How is related to the Hull/White model? was further extended in the Hull-White model Asumes short rate is normal distributed Mean reverting process (under Q) Drift in interest rate will disappear if a : how fast the short rate will reach the long-term mean value b: the long run equilibrium value towards which the interest rate reverts Term structure can be determined as a function of r(t) once a, b and are chosen. r = = b/a Slide 6 How is related to the Hull/White model? Ho-Lee model is a particular case of Hull & White model with a=0 Assumes a normally distributed short-term rate SR drift depends on time makes arbitrage-free with respect to observed prices Does not incorporate mean reversion Short rate dynamics: (instantaneous SD) constant (t) defines the average direction that r moves at time t Slide 7 Market price of risk proves to be irrelevant when pricing IR derivatives Average direction of the short rate will be moving in the future is almost equal to the slope of instantaneous forward curve Slide 8 No-arbitrage yield curve model Parameters are consistent with bond prices implied in the zero coupon yield curve In absence of default risk, bond price must pull towards par as it approaches maturity. Assumes SR is normally distributed & subject to mean reversion MR ensures consistency with empirical observation: long rates are less volatile than short rates. HWM generalized by Vasicek (t) deterministic function of time which calibrated against the theoretical bond price V(t) Brownian motion under the risk-neutral measure a speed of mean-reversion Slide 9 Input parameters for HWM a : relative volatility of LR and SR : volatility of the short rate Not directly provided by the market (inferred from data of IR derivatives) Slide 10 Call option, two step, t=1, strike price =0.40. Our account amount \$100. Probabilities: 0.25,0.5 & 0.25 Payoff at the end of second time step: Rollback precedure as: (pro1*valu1+...+pro3*valu3)e -rt 0.00% E 4.40%(4) 0.00%B 3.81%(0.963)F 3.88% A 3.23%(0.233)C 3.29%G 3.36% 0.00%D 2.76%H 2.83% 0.00% I 2.31% 0.00% Slide 11 Alternative branching possibilities The pattern upward is useful for incorporating mean reversion when interest rates are very low and Downward is for interest rates are very high. Slide 12 HWM for instantaneous rate r: First Step assumptions: all time steps are equal in size t rate of t,(R) follows the same procedure: New variable called R* (initial value 0) Slide 13 : spacing between interest rates on the tree for error minimization. Define branching techniques Upwards a > 0 Normal a = 0 Define probabilities(depends on branching) probabilities are positive as long as: Straight / Normal Branching Slide 14 With initial parameters: = 0.01, a = 0.1,t = 1 R=0.0173,j max =2,we get: Slide 15 Second step convert R* into R tree by displacing the nodes on the R*-tree Define i as (it),Qi,j as the present value of a security that payoff \$1 if node (I,j) is reached and 0.Otherwise,forward induction With continuously compounded zero rates in the first stage Q 0,0 is 1 0 =3.824% 0 right price for a zero-coupon bond maturing at time t Q 1,1 =probability *e -rt =0.1604 Q 1,0 =0.6417 and Q 1,-1 =0.1604. MaturityRate(%) 0.53.43 1.03.824 1.54.183 2.04.512 2.54.812 3.05.086 Slide 16 Bond price(initial structure) = e -0.04512x2 =0.913 Solving for alfa1= 0.05205 It means that the central node at time t in the tree for R corresponds to an interest rate of 5.205% Using the same method, we get: Q2,2=0.0182,Q2,0=0.4736,Q2,-1=0.2033 and Q2,-2=0.0189. Calculate 2,Q 3,j s will be found as well. We can then find 3 and so on Slide 17 Finally we get: Slide 18 Slide 19 Underlying interest rate Payoff date American options Slide 20 4,0 % 3,5 % 3,2 % 4,0 % 5,0 % 5,4 % 4,0 % 4,6 % 3,0 % 3,7 % Slide 21 Thank You!!! ##### Arvid Pardo â€“ a diplomat with a mission ... 15 ARVID PARDO A DIPLOMAT WITH A MISSION tasks, merits,
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