A supermartingale approach to interest rates

Cezar Chirila

February 3, 2010

Cezar Chirila () A supermartingale approach to interest rates February 3, 2010 1 / 23

Motivation

We are interested in developing an interest rate model, and for that we

need to model the prices of zero bonds for all maturities T .
The main properties that the model focuses on is the absence of arbitrage,
the completion of markets and the non-negative interest rate assumptions.

Cezar Chirila () A supermartingale approach to interest rates February 3, 2010 2 / 23

Notations

Denote by B(t, T ) the price of a zero bond with maturity T at time

t ≤ T .We consider the prices of the zero bonds as stochastic processes
defined on a filtered probability space (Ω, F, (Ft )t≥0 , P).

Cezar Chirila () A supermartingale approach to interest rates February 3, 2010 3 / 23

Arbitrage

An arbitrage is a self financing strategy θ such that the initial cost is

negative (V0 (θ) ≤ 0) and there exists some t > 0 such that Vt (θ) ≥ 0
P − a.s and P(Vt (θ) > 0) > 0 (By Vt (θ) we have denoted the value at
time t of the portfolio θ). Note that the notion of an arbitrage refers to
the class of probabilities equivalent to P.

Cezar Chirila () A supermartingale approach to interest rates February 3, 2010 4 / 23

Numeraire

A numeraire N = (Nt )t≥0 is any strict positive value process of some

self-financing strategy. Given a numeraire N we call a probability measure
QN ≡ P an equivalent martingale measure for the numeraire N if all
primary security price processes expressed in numeraire units are
QN -martingales, that is, the process
 
B(t, T )
Nt t≤T

is a QN -martingale.

Cezar Chirila () A supermartingale approach to interest rates February 3, 2010 5 / 23

Theorem

Theorem : The condition for the absence of an arbitrage: if there exists a

numeraire pair (N, QN ), then there is no arbitrage in the set of admissible
strategies.

Because we are interested in a model with no arbitrage opportunities, with

respect with the above theorem we need to impose the conditions on the
zero bond prices:
 
1
B(t, T ) = Nt · EQN |Ft
NT

Cezar Chirila () A supermartingale approach to interest rates February 3, 2010 6 / 23

Particular case: Short rate models

Particular cases of this construction are the short rate models, which we
get by considering
Rt
rs ds
Nt = e 0

RT
Then B(t, T ) = E (e − t Rrs ds |Ft ) and in case we consider rs as a Markov
T
process, B(t, T ) = E (e − t rs ds |σ(rt )).

Cezar Chirila () A supermartingale approach to interest rates February 3, 2010 7 / 23

Non-negative interest rate

Another property that we want to introduce in our model is the fact that
for two maturity dates, T < S, we should have B(t, T ) ≥ B(t, S),
equivalent with a non-negative interest rate assumption. That gives us the
relation:
   
1 1
Nt EQN |Ft ≥ Nt EQS |Ft
NT NS

Cezar Chirila () A supermartingale approach to interest rates February 3, 2010 8 / 23

Non-negative interest rate

By replacing t with T , we obtain:

 
1 1
≥ EQ N |FT
NT NS
To conclude, for our
model to consider only non-negative interest rates, we
must have that N1 t is a QN -supermartingale.

Cezar Chirila () A supermartingale approach to interest rates February 3, 2010 9 / 23

The general model

The most general case of constructing a model is by starting with a

numeraire pair, and obtaining arbitrage-free prices of zero bonds from the
ecuation  
1
B(t, T ) = Nt · EQN |Ft .
NT

Cezar Chirila () A supermartingale approach to interest rates February 3, 2010 10 / 23

The Rational Log Normal model

One way in which we can get the numeraire with the above properties is to
consider
1
= Mt · g (t) + f (t)
Nt
where g , f are deterministic decreasing functions, and Mt is a positive
martingale. We consider a Brownian motion W , the filtration F W
generated by it, and the martingale Mt as being:
Rt Rt
σ(s)dWs − 21 σ(s)2 dt
Mt = e 0 0

Cezar Chirila () A supermartingale approach to interest rates February 3, 2010 11 / 23

Zero bond prices

A zero bond price is given by:

 
1
B(t, T ) = Nt · EQN |Ft =
NT
1 Mt g (T ) + f (T )
= E (MT g (T ) + f (T )|Ft ) = .
Mt g (t) + f (t) Mt g (t) + f (t)

Cezar Chirila () A supermartingale approach to interest rates February 3, 2010 12 / 23

Caplet on Libor

We can use this model to get closed form formulas for options on the
interest rate. For example, let us consider caplet on Libor L from T1 to
T2 , which pays ∆ max(L − K , 0) on the maturity date T2 , where
∆ = T2 − T1 on the corresponding day convention, e.g. act/360.

Cezar Chirila () A supermartingale approach to interest rates February 3, 2010 13 / 23

Caplet on Libor

On time T1 , the caplet has the discounted value:

1 + ∆K +
+
∆(L − K )+
  
1
= 1− = (1 + ∆K ) − B(T1 , T2 )
1 + ∆L 1 + ∆L 1 + ∆K
.
Therefore, we can consider a caplet as a put on a zero bond. So we will
focus on giving a close price formula for the puts and calls on the zero
bonds.

Cezar Chirila () A supermartingale approach to interest rates February 3, 2010 14 / 23

Pricing calls

Giving the arbitrage-free context, the price for a call on the bond
B(T1 , T2 ), payed at T1 , will be given by:

(B(T1 , T2 ) − K )+
 
N0 · EQN |F0
N T1

Cezar Chirila () A supermartingale approach to interest rates February 3, 2010 15 / 23

Pricing calls

V0 ((B(T1 , T2 ) − K )+ ) =
+
T1 g (T2 )+f (T2 )
M
1
f (0)+g (0) · (MT1 g (T1 ) + f (T1 )) · EQN MT1 g (T1 )+f (T1 ) −K =
1
f (0)+g (0) · EQN (MT1 · [g (T2 ) − K · g (T1 )] + [f (T2 ) − K · f (T1 )])+

Cezar Chirila () A supermartingale approach to interest rates February 3, 2010 16 / 23

Notations

1
Let G = g (T2 ) − K · g (T1 ), F = f (T2 ) − K · f (T1 ) and R = f (0)+g (0) .

F
For the case where G < 0, consider y is given by
qR R T1
T1 +1 σ(s)2 ds
R T1
σ(s)2 ds− 21 σ(s)2 ds ln −F
ey 0 0 G + F = 0, so y = GqR 2 0
T1 2
0 σ(s) ds

R T1 R T1
ln F
−1 σ(s)2 ds ln F
+1 σ(s)2 ds
We use d1 = qR 2 0
−G
and d2 = qR 2 0
−G
.
T1 2 T1 2
0 σ(s) ds 0 σ(s) ds

Cezar Chirila () A supermartingale approach to interest rates February 3, 2010 17 / 23

Pricing calls

We distinguish 4 cases depending on the sign of F and G .

F > 0, G >0 V0 ((B(T1 , T2 ) − K )+ ) = R · (G + F )

F > 0, G <0 V0 ((B(T1 , T2 ) − K )+ ) = R · (G · N(d1 ) + F · N(d2 )
F < 0, G >0
F < 0, G <0 V0 ((B(T1 , T2 ) − K )+ ) = 0

Cezar Chirila () A supermartingale approach to interest rates February 3, 2010 18 / 23

Pricing calls

Translated back to the strike of our call, we get also a natural financial
explanation:

Strike Call price

(T2 ) g (T2 )
K > max{ ff (T ,
1 ) g (T1 )
} R · (G + F )
(T2 ) g (T2 )
max{ ff (T ,
1 ) g (T1 )
} > K > min{ ff (T 2 ) g (T2 )
(T1 ) , g (T1 ) } R(GN(d1 ) + FN(d2 ))
K< min{ ff (T 2 ) g (T2 )
(T1 ) , g (T1 ) } 0

Cezar Chirila () A supermartingale approach to interest rates February 3, 2010 19 / 23

Pricing calls

MT1 g (T2 )+f (T2 )

The price of the bond B(T1 , T2 ) is given by MT1 g (T1 )+f (T1 ) and for fixed
T1 and T2 we get

f (T2 ) g (T2 ) f (T2 ) g (T2 )

max{ , } > B(T1 , T2 ) > min{ , }
f (T1 ) g (T1 ) f (T1 ) g (T1 )

Cezar Chirila () A supermartingale approach to interest rates February 3, 2010 20 / 23

Pricing calls

The results say the price will be a constant on time if the strike is chosen
such that the call is always in the money
(T2 ) g (T2 )
(K > max{ ff (T ,
1 ) g (T1 )
} > B(T1 , T2 )) or out of the money
(K < min{ ff (T 2 ) g (T2 )
(T1 ) , g (T1 ) } < B(T1 , T2 )).

Cezar Chirila () A supermartingale approach to interest rates February 3, 2010 21 / 23

Pricing calls

Furthermore, our model implies the boundness of the bond prices, and
from the relation

ln B(t, T )
r (t, T ) = −
T −t
we get that the interest rates are also bounded.

Cezar Chirila () A supermartingale approach to interest rates February 3, 2010 22 / 23

Levy process

We will continue further with a generalized method of obtaining the

martingale Mt . We will consider a Levy process X , and set

e σXt
Mt =
Ee σXt
By considering Xt = Wt , a Brownian motion, we particularize for the case
1 2
of Rational Log Normal model, Mt = e σWt − 2 σ t .

Cezar Chirila () A supermartingale approach to interest rates February 3, 2010 23 / 23