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 are endogenous models and 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 a few observed market prices ("calibration") of zero coupon bonds or linear products such as forward rate agreements or swaps, typically, or a best fit is done to these linear products to find the endogenous short rate models parameters that are closest to the market prices. This does not allow for fitting options like caps, floors and swaptions as the parameters have been used to fit linear instruments instead. This problem is overcome by allowing the parameters to vary deterministically with time, or by adding a deterministic shift to the endogenous model. In this way, exogenous models such as 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, and the remaining parameters can be used for options calibration. The implementation is usually via a (
binomial) short rate tree or simulation; see and
Monte Carlo methods for option pricing, although some short rate models have closed form solutions for zero coupon bonds, and even caps or floors, easing the calibration task considerably. We list the following endogenous models first. •
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. In this approach, the short rate follows an
arithmetic Brownian motion. • 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. The second form is the more common, and makes the parameters interpretation more direct, with the parameter a being the speed of mean reversion, the parameter b being the long term mean, and the parameter \sigma being the instantaneous volatility. In this short rate model an
Ornstein–Uhlenbeck process is used for the short rate. This model allows for negative rates, because the probability distribution of the short rate is Gaussian. Also, this model allows for closed form solutions for the bond price and for bond options and caps/floors, and using
Jamshidian's trick, one can also get a formula for swaptions. or Dothan model (1978) explains the short rate as dr_t = \theta r_t\, dt + \sigma r_t\, dW_t. In this model the short rate follows a
geometric Brownian motion. This model does not have closed form formulas for options and it is not mean reverting. Moreover, it has the problem of an infinite expected bank account after a short time. The same problem will be present in all lognormal short rate models The interpretation of the parameters, in the second formulation, is the same as in the Vasicek model. The Feller condition 2 ab>\sigma^2 ensures strictly positive short rates. This model follows a Feller square root process and has non-negative rates, and it allows for closed form solutions for the bond price and for bond options and caps/floors, and using
Jamshidian's trick, one can also obtain a formula for swaptions. Both this model and the Vasicek model are called affine models, because the formula for the continuously compounded spot rate for a finite maturity T at time t is an affine function of r_t. The parameter \theta_t allows for the initial term structure of interest rates or bond prices to be an input of the model. This model follows again an arithmetic Brownian motion with time dependent deterministic drift parameter. • The
Hull–White model (1990)—also called the extended Vasicek model—posits dr_t = (\theta_t-\alpha_t 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 distribution of the short rate is normal, and the model allows for negative rates. The model with constant \alpha and \sigma is the most commonly used and it allows for closed form solutions for bond prices, bond options, caps and floors, and swaptions through Jamshidian's trick. This model allows for an exact calibration of the initial term structure of interest rates through the time dependent function \theta_t.
Lattice-based implementation for Bermudan swaptions and for products without analytical formulas is usually
trinomial. • 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. The model has no closed form formulas for options. Also, as all lognormal models, it suffers from the issue of explosion of the expected bank account in finite time. • 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). This approach is effectively similar to "the original
Salomon Brothers model" (1987), also a lognormal variant on Ho-Lee. • The CIR++ model, introduced and studied in detail by
Brigo and
Mercurio used the CIR model but instead of introducing time dependent parameters in the dynamics, it adds an external shift. The model is formulated as dx_t = a(b-x_t)\, dt + \sqrt{x_t}\,\sigma\, dW_t, \ \ r_t = x_t + \phi(t) where \phi is a deterministic shift. The shift can be used to absorb the market term structure and make the model fully consistent with this. This model preserves the analytical tractability of the basic CIR model, allowing for closed form solutions for bonds and all linear products, and options such as caps, floor and swaptions through Jamshidian's trick. The model allows for maintaining positive rates if the shift is constrained to be positive, or allows for negative rates if the shift is allowed to go negative. It has been applied often in credit risk too, for credit default swap and swaptions, in this original version or with jumps. The idea of a deterministic shift can be applied also to other models that have desirable properties in their endogenous form. For example, one could apply the shift \phi to the Vasicek model, but due to linearity of the Ornstein-Uhlenbeck process, this is equivalent to making b a time dependent function, and would thus coincide with the Hull-White model. • The
Longstaff–Schwartz model (1992) supposes the short rate dynamics are given by :: \begin{align} dX_t & = (a_t-b X_t)\,dt + \sqrt{X_t}\,c_t\, dW_{1t}, \\[3pt] d Y_t & = (d_t-e Y_t)\,dt + \sqrt{Y_t}\,f_t\, dW_{2t}, \end{align} : where the short rate is defined as :: dr_t = (\mu X + \theta Y)\,dt + \sigma_t \sqrt{Y} \,dW_{3t}. • The
Chen model (1996) which has a stochastic mean and volatility of the short rate, is given by :: \begin{align} dr_t & = (\theta_t-\alpha_t)\,dt + \sqrt{r_t}\,\sigma_t\, dW_t, \\[3pt] d\alpha_t & = (\zeta_t-\alpha_t)\,dt + \sqrt{\alpha_t}\,\sigma_t\, dW_t, \\[3pt] d\sigma_t & = (\beta_t-\sigma_t)\,dt + \sqrt{\sigma_t}\,\eta_t\, dW_t. \end{align} • The two-factor Hull-White or G2++ models are models that have been used due to their tractability. These models are summarized and shown to be equivalent in Brigo and Mercurio (2006). This model is based on adding two possibly correlated Ornstein-Uhlenbeck (Vasicek) processes plus a shift to obtain the short rate. This model allows for exact calibration of the term structure, semi-closed form solutions for options, control of the volatility term structure for instantaneous forward rates through the correlation parameter, and especially for negative rates, which has become important as rates turned negative in financial markets. ==Other interest rate models==