, -,.

4
5
647 </ 7,6 =>(? 7,6 ) Ito Lemma: Dollar Capital gain
𝑟# 𝑡, 𝑇 = 𝑛 ∗ (𝑒 / − 1) 𝑟# = 𝑛 ∗ 𝑧 𝑡, 𝑇 / | 𝑟 𝑡, 𝑇 = 𝑛 ∗ ln 1 + 𝑟 𝑡, 𝑇 = − |
# (647) 𝜕𝑉 𝜕𝑉 1 𝜕E𝑉 E 𝜕𝑉
</ 7,6 4# 647 D 𝒅𝑽𝒕 = + 𝑚 𝑡, 𝑟7 + 𝑆 𝑡, 𝑟7 𝑑𝑡 + 𝑆(𝑡, 𝑟7 ) 𝑑𝐵7
𝑧 𝑡, 𝑇 = 1 + 𝑧 𝑡, 𝑇 = exp −𝑟 𝑡, 𝑇 ∗ 𝑇 − 𝑡 𝑓# 𝑡, 𝑇D , 𝑇E = 𝑛 ∗ ( 5 − 1) | 𝑑𝑡 𝑑𝑟7 2 𝑑𝑟7E 𝑑𝑟7
#
F 7,65 ,6G / .G H.5
FPE Feynman-Kac
? 7,6G => J K,L5 ,LG
𝐹 𝑡, 𝑇D , 𝑇E = 𝑓 𝑡, 𝑇D , 𝑇E = − 𝐹 𝑡, 𝑇D , 𝑇E = 𝑒 4N 7,65 ,6G ∗ 6G 465
-FPE: 𝐸 𝑑𝑉7 =
¢£
+
¢£
𝑚 𝑡, 𝑟7 +
D ¢G£
𝜎 E ×𝑑𝑡 = 𝑟7 𝑉7
? 7,65 LG – L5
q7 q<- E q<-G
1 − 𝑧 𝑜, 𝑇 1
𝑐 𝑡, 𝑡# = 𝑛 ∗ 𝑧 𝑡, 𝑇D = ¢¤ ¢¤ D ¢G¤
𝑧 0, 𝑇R 𝑐(𝑡, 𝑇D ) -FPE Bzc: 𝐸 𝑑𝑍7 = + 𝜃7 + 𝜎 E 𝑑𝑡 = 𝑟7 𝑍(𝑟7 , 𝑇)
q7 q<- E q<-G
1+
𝑛 ¢£ ¢£ D ¢G£
Qualitative answers -Under RN: 𝐸 ∗ 𝑑𝑉7 = 𝑑𝑡 + 𝑚 ∗ 𝑡, 𝑟7 + 𝜎 E ×𝑑𝑡 = 𝑟7 𝑑𝑡 𝑉7
q7 q<- E q<-G
-Interest rates that are annualized rate easily comparable across different maturities, while discount factors (Z(t,T)) ¦ ∗ q£-
àBy No-arbitrage: = 𝑟7 𝑑𝑡 à The left-hand side E[dVt]/Vt is the instantaneous
are not directly comparable £-

-Flat volatility are comparable across different strike rate (rk) and maturities T1 of options, while dollar option prices (overnight) return on the investment in the risky asset, while the right-hand side is the
are not. overnight risk-free return at a bank. When investors are risk-neutral, they care only about
-B(LT) are more sensitive to a var of int rate than B(ST) & B(LC) are more sensitive than B(HC) the expected returns, so by no arbitrage the two must 2 indeed be equal.
-Floating Inst: they have pretty small duration compared to fixed coupon analogues || Dz = B(t,T) àThe 𝒎 * 𝒕, 𝒓𝒕 is the adjusted drift in the short rate under the risk-neutral measure
-Libor/repos: LIBOR is the rate for uncollateralized borrowing on the interbank market, while repo borrowing is which takes into account risk-aversion of investors. The drift is larger under the risk-
collateralized by the bonds or other instruments to be repurchased. Posting collateral generally helps to reduce the neutral measure that under physical measure 𝑚 ∗ 𝑡, 𝑟7 > 𝑚 𝑡, 𝑟7 because larger drift in
counterparty risk. short rate makes bond prices cheaper and creates the premium for investors exposed to
- Repos: bet prices will increase Repos inverse: bet prices will decline interest rate risk.
-Lending LIBOR/REPOS:Lending at libor doesn’t change because no collate and rate higher because of counterparty Hull white model
risk and when collateral is scarce, lending at repo becomes more exp. (r goes down) since you get a more val. Collater. àA higher y implies a more aggressive monetary policy rule, which r are increased more
- CRAs use the physical probability. Risk-averse investors who entirely rely on the credit rating will overprice the debt, quickly to prevent higher inflation
as the rating they use does not reflect the adjusted risk-neutral probabilities and there is no premium for bearing risk àbecause of mean-reversion the initial shock of the short rate today is expected to revert
Forward and flat volatility: thus the effect on LT bonds is smaller àST rate duration is lower
𝑽 𝒕,𝒓𝒕
-Why is there no data point for T=0.25 Normalized value of Bzc : 𝑽𝒕 = 𝒁 𝒕,𝑻
if we have to write V(t,r_t) = 𝑉7 𝑍 𝑡, 𝑇
àbecause as quarterly caplets/floorlets maturing at T=0.25 are ¢¤- ¢£- ¢¤- ¢£- D ¢ G ¤- ¢ G £- ¢£- ¢¤-
𝑟7 𝑉7 𝑍7 = 𝑉7 + 𝑍7 + 𝑚 𝑡, 𝑟7 𝑉7 + 𝑍7 + 𝑉7 + 𝑍7 +2
linked to the current level of interest rate, so there is no uncertainty about their payoff (no volatility) ¢7 ¢7 ¢<- ¢<- E ¢<-G ¢<-G ¢<- ¢<-
-why forward vol equal to flat vol at T=0.5? à the 0.25 caplet is determin., this why flat/fwd vol are equalt T=0.5 ¢¤ ¢¤ D ¢ G ¤-
𝑟7 𝑍7 = + à 𝑟7 𝑉7 𝑍7 − 𝑟7 𝑍7 × 𝑉7 = 0
𝑚 𝑡, 𝑟7 +
¢7 E ¢<-G
¢<-
In-arrears ¢£-
¢£ ¢£ ¢¤ D ¢G£
-𝑺𝒘𝒂𝒑: 𝐶𝐹 0.75 = 𝑁∆(𝑟# 𝑇R , 𝑇R^D − 𝑐) - 𝒄𝒂𝒑: 𝐶𝐹 0.75 = 𝑁∆𝑚𝑎𝑥(𝑟# 𝑇R , 𝑇R^D − 𝑟c ; 0) à 0 = 𝑍7 + - 𝑚 𝑡, 𝑟7 + - - + 𝑍7 G-
¢7 ¢<- ¢<- ¢<- E ¢<-
Ex: 𝒄𝒂𝒑 ∶ 𝑁∆𝑚𝑎𝑥(𝑟# 0.75,1 − 𝑟c ; 0) vs cap normal: 𝑁∆𝑚𝑎𝑥(𝑟# 0.5,0.75 − 𝑟c ; 0) cash flow(T) = 0.75 ¢£- ¢£- ∗ D ¢¤- D ¢ G £- E
àunder FRN: + 𝑚 𝑡, 𝑟7 + + 𝜎 = 𝟎
à a standard caplet pays exactly the same CF 3 months later, so the market value is lower if r are positive ¢7 ¢< ¤ 7,6 ¢<
- E ¢< G - -
j. j. p 4qD àwhen inves. are risk averse, everything is the same expect m() drift is replaced by m*
Merton mode of default: 𝐸 𝑅𝑒𝑐𝑜𝑣𝑒𝑟𝑦 𝑅𝑎𝑡𝑒 = 𝐸 |𝐴 6 < 𝐷 = 𝐸 ×
k k p 4qE How to get FPE from Feynman-Kac
àIn the Merton model as A_t today goes upà E(RR) goes up too!
-Model: 𝑍 = 𝑒 j 6,7 4(647)×< and 𝑑𝑟7 = 𝜽𝒕 ×𝑑𝑡 + 𝝈×𝑑𝐵7
-Explain why a similar calculation cannot be carried out for the standard first passage model of default?
-Applying Ito Lemma:
àIn the first passage model default happens the first time assets At hit the default boundary D/At is likely to be 1 at
¢£ ¢£ 𝟏 ¢G£ ¢£
default The above calculation would not make any sense in such a case. In Merton model however it makes sense 𝒅𝑽𝒕 = + 𝒎 𝒕, 𝒓𝒕 + 𝑺𝟐 𝒕, 𝒓𝒕 𝒅𝒕 + 𝑺(𝒕, 𝒓𝒕 ) 𝒅𝑩 𝒕
q7 q<- 𝟐 q<-G q<-
because we focus only at default T (maturity) only. 𝜕𝑍 𝜕𝐴 𝑡, 𝑇
First passage model 1) = + 𝑟7 ∗ 𝑍,
𝜕𝑡 𝜕𝑡
-What happens to the credit spread d(t,T) as time to maturity T increases, under the first-passage model with fixed 𝜕𝑍
default boundary? 2) = − 𝑇 − 𝑡 ∗ 𝑍,
𝜕𝑟7
à With zero debt-to-equity at the long end there should be no difference between defaultable and default-free
𝜕E𝑍
bonds, so the credit spread should be close to zero. 3) E = 𝑇 − 𝑡 E ∗ 𝑍
𝜕𝑟7
Local volatility
<x ^N5 <x ^Ny ^(N5 4Ny )
𝜕𝑉
An increase in f0 is equivalent to : 𝜎stuvc 𝑟c , 𝑓D = 𝜎twv = 𝜎twv = 𝜎stuvc 𝑟c + 𝑓D − 𝑓K , 𝑓K 4) 𝑆(𝑡, 𝑟7 ) 𝑑𝐵7 = − 𝑇 − 𝑡 ∗ 𝑍
E E 𝑑𝑟7
Continuously compounded forward rate f(0,T,T+delta)
MBS pass-through
-When r decline, so PSA is likely to increase à thus when r declines, value MBS with PSA fixed goes up and exhibits
positive convexity. But generally, PSA increases when r declines Therefore the MBS value gets regions with negative
effective conv. - How does this expression help to calibrate the Ho-Lee Model to match the term
PSA: Industry Benchmark rate of prepayment speed à100% PSA
-a lower PSA results in lower total principal payments early on structure? à The result helps in the following sense: Now we can
³´ K,µ ³´ K,µ
Graph about credit rating (CRA) simply take the observed forward curve to estimate and obtained 𝜃7 = +
³µ ³µ
If they were downgrading firms too quickly then you would expect lower default rates of downgraded v.s. unchanged 𝜎 E instead of manually calibrating the discretized Ho-Lee risk neutral tree step-by-step.

firms, as an example. The evidence above is the opposite, which suggests that they do not downgrade promptly Special case of Interest rate derivative
enough.
Market Price of interest rate risk 𝝀𝟎
-How should 𝝀𝟎 have changed if you used the physical probabilities of short rate movement rather than risk-neutral
? 7,6
probabilities? Term structure: 𝑟 𝑡, 𝑇 = − ln
647
àSo when we use the physical probability to compute 𝜆K since Pu(0.5,1) < Pd(0.5,1) the expectation EP(0.5,1)⇤ will go - Why in this model all shifts of the term structure are parallel shifts?
up, so the numerator becomes > 0 but denominator would be < 0 à 𝜆K < 0 (decreases compared to zero before, this àNo matter the horizo(T-t) the effect of shocks to rt is same so we have only parallel shift
corresponds to an increase in the risk-premium captured by the numerator of 𝜆K ). Forward Risk-Neutral Measure
- When investors are risk-averse, risk-neutral default intensity 𝝀∗𝟎 tends to be higher than actual physical-world
- 1) An in-arrears forward contract on the 2-times compounded LIBOR with delivery rate
default intensity 𝝀𝟎
rK and notional N that matures at T and pays at maturity: (N/2)(r2(T,T +0.5) rK).
à Since defaults tend to occur more often when risk-averse investors have lower consumption, they will require a
Question: How many zero-coupon bonds Z(0,T +0.5) this forward contract is worth at t = 0
premium and would buy relatively cheaper defaultable bonds with relatively higher yields to compensate for <G 6,6^K.¶ 4<x
unwanted default risk. under the (T + 0.5)-forward risk-neutral measure? à𝐸 ∗ 𝑁(
E? 6,6^K.¶
Risk-Neutral vs physical prob - 2) Payoff at T =F Z(T,T2) and Taking the numeraire to be Z(t,T), write down the value of
-How should a Bzc has changed if you used the physical probabilities of short rate movement rather than risk-neutral the forward contract as of today t = 0 under the T -forward risk-neutral measure. Then,
probabilities? similarly, write down the value of a zero-coupon bond Z(t,T2) as of today t = 0 under the T-
àThe physical probability of an upward movement is smaller than the risk-neutral probability, while bond prices are forward risk-neutral measure. Use your results to find the value of F that makes the
F4¤ 6,6G
smaller when interest rates are higher. Under physical probabilities (when investors are risk-neutral) the bond prices forward contract above worth zero today à 𝑍 0, 𝑇 𝐸N = 𝑍 0, 𝑇 𝐹−
¤ 6,6
will be higher (so their yields will be lower).
àRisk-averse investors require premium for holding these bonds, so the bonds must be cheaper compared to a world 𝐸N 𝑍 𝑇, 𝑇E and the value of Bzc : 𝑍 0, 𝑇 𝐸N 𝑍 𝑇, 𝑇E = 𝑍 0, 𝑇E
¤ K,6G
with risk-neutral investors. Thus the risk-neutral probability of an upward movement in interest rates must be higher àF=𝐸N 𝑍 𝑇, 𝑇E = = 𝐹(0, 𝑇, 𝑇E )
¤ K,6
than the true physical probability, as the higher interest rates make bonds with fixed payments cheaper.
- 3) Consider an in-arrears forward contract on the n-times compounded LIBOR with
Black Formula: delivery rater K and notional N that matures at T and pays at maturity: N∆ (rn(T,T+D)- rK).
Caplet(0,T_1)= 𝑁 ∆ 𝑍 0, 𝑇D^R ∗ 𝑓# 0, 𝑇R , 𝑇R^D 𝑁 𝑑1 − 𝑟c 𝑁(𝑑2) à Cap(0,T) = Sum(caplets) Question: How many Bzc Z(0,T) this forward contract is worth at t = 0 under the T-FRN
Floorlet(0,T_1)= 𝑁 ∆ 𝑍 0, 𝑇D^R ∗ 𝑟c 𝑁 −𝑑2 − 𝑓# 0, 𝑇R , 𝑇R^D 𝑁 −𝑑1 à Floor(0,T) = Sum(floorlets) £y
D N/ K,6ƒ ,6ƒ†5 à = 𝑁 ∗ ∆ ∗ (𝐸N ∗ (𝑟# 𝑇, 𝑇 + ∆ − 𝑟c ) and
¤(K,6)
d1= log + 0.5𝜎𝑠𝑞𝑟𝑡 𝑇R 𝑎𝑛𝑑 𝑑E = 𝑑D − 𝜎𝑠𝑞𝑟𝑡(𝑇R )
€•‚<7 6ƒ <‡ under T-FRN: 𝐸N ∗ (𝑟# 𝑇 − ∆, 𝑇 = 𝑓# 0, 𝑇 − ∆, 𝑇 𝒃𝒖𝒕 𝐸N ∗ (𝑟# 𝑇, 𝑇 + ∆ ≠ 𝑓# 0, 𝑇, 𝑇 + ∆
àcaplet: In order to use Black formula we have everything except s, which is forward volatility - 4) You have just entered into a forward contract to deliver a zero-coupon bond one year
àcap: To use the Black formula I would value the three caplets separately (Black formula would be used only for last from now at T1 = 1 maturing at T2 = 2 at a predetermined forward price today K = $100.
two caplets maturing at 0.5 and 0.75) and would plug in the 3-quarters flat volatility instead of sigma You know that Z(0,1) = 0.95 and F(0,1,2) = 0.92. Question: Explain whether the value of
. Š‹-
-•5 7× 5†Œ G ∆Ž D ‘F- ∆Ž D this contract today is greater or equal or less than (100*F(0,1,2) K)?
6
Duration:𝐷 = → = −𝐷×∆𝑟 convexity: 7’D 𝑡E + 𝑡 → = −𝐷×∆𝑟 + 𝐶𝑋 ∆𝑟 E
Žy Ž Žy D^• G D^• - Ž E à Thus the value of the forward contract is Z(0,1)[100F(0,1,2)] 100] < 100F(0,1,2) 100
Defaultable zero-coupon bond Answer: The value is smaller than the expression given because the forward price K = 100
D <^”∗ •∗ is to be paid at t = 1 rather than at t = 0
-Probability of default: 1 − 𝑒 4”7 and Exp time to def = and Risk-adj SR=𝑅 = and Default adj ST = 𝑟 + 𝜆∗ 𝐿∗
” D4” ∗ •
∗
K.D™ 4D
Invoice Price=Quoted price+accrued interestàAI=days held/#days *coupon rate*Nominal
98=100 𝑒 4”7 + 1 − 𝑒 4”7 1 − 𝐿∗ and X1=98 1 + 𝑒 4”7 + 98 ∗ 1 − 𝑒 4”7 (1 − 𝐿∗ ) Fºj
Forward rate agreement: 𝑉Ntwu7R# 𝑡 = 𝑉 NR»¼q 𝑡 − 𝑉 Ntwu7R#½ (𝑡)
š
-𝑽𝒇𝒍𝒐𝒂𝒕𝒊𝒏𝒈 (𝒕) = 𝑍 𝑡, 𝑇D ∗ 𝑁 𝑎𝑛𝑑 𝑽𝒇𝒊𝒙𝒆𝒅 𝒕 = 𝑍 𝑡, 𝑇D ∗ 𝑁 ∗ 1 + 𝑓# 0, 𝑇D , 𝑇E ∗ ∆