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Pricing Models
Pricing Models
The Black-Scholes model
The Black-Scholes model
[PDF] F. Black and M. Scholes. The Pricing of Options and Corporate Liabilities. Journal of Political Economy (1973)
[PDF] R. Merton. Theory of Rational Option Pricing. Bell Journal of Economics and Management Science (1973)
Merton Model with Jump, R. Merton, Option pricing when underlying stock returns are discontinuous, J. Financial Economics, 3 (1976), pp. 125–144.
Jump Model, S. G. Kou , A Jump-Diffusion Model for Option Pricing for Option Pricing, 2002
Finance Without Brownian Motions: An Introduction to Simplified Stochastic Calculus, Ales , Ruf
SABR
SABR
Volatility
Volatility
Local Vol - Dupire model: Pricing with a Smile Bruno Dupire Bloomberg, 1994
Emanuel Derman Iraj Kani , The Volatility Smile and Its Implied Tree
Emanuel Derman and Iraj Kani. Riding on a smile. Risk, 7, 01 1994.
Rubenstein, M. (1994) "Implied Binomial Trees," Journal of Finance 49 (3), 771-818.
CEV Model John C. Cox. The constant elasticity of variance option pricing model. The Journal of Portfolio Management, 23(5):15–17, 1996.
IV in the CEV Model, Patrick S. Hagan and Diana E.Woodward. Equivalent black volatilities. Applied Mathematical Finance, 6(3):147–157, 1999.
SABR Model, Managing Smile Risk ,Patrick S. Hagan , Deep Kumar , Andrew S. Lesniewski,2002
SVI Model Jim Gatheral and Antoine Jacquier. Arbitrage-free SVI volatility surfaces. 2004 & 2014
Peter Jäckel. Clamping down on arbitrage. Wilmott, 2014(71):54–69.
Interest rates
Interest rates
John Hull and Alan White, "The pricing of options on interest rate caps and floors using the Hull–White model" in Advanced Strategies in Financial Risk Management, Chapter 4, pp. 59–67.
Hull-White Numerical Procedures for Implementing Term Structure Models I: Single-Factor Models, Journal of Derivatives, Fall 1994, pp. 7-16 (with Alan White)
Hull-White Numerical Procedures for Implementing Term Structure Models II: Two-Factor Models, Journal of Derivatives, Winter 1994, pp. 37-48 (with Alan White)
Longstaff &Schwartz F. A. Longsta® and E. S. Schwartz. Interest rate volatility and theterm structure: a two factor general equilibrium model. Journalof Finance, 47:1259-1282, 1992
A short-rate model, in the context of interest rate derivatives, is a mathematical model that describes the future evolution of interest rates by describing the future evolution of the short rate, usually written .
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The short rate Models Review
The short rate Models Review
Under a short rate model, the stochastic state variable is taken to be the instantaneous spot rate.[1] The short rate, , then, is the (continuously compounded, annualized) interest rate at which an entity can borrow money for an infinitesimally short period of time from time . Specifying the current short rate does not specify the entire yield curve. However, no-arbitrage arguments show that, under some fairly relaxed technical conditions, if we model the evolution of as a stochastic process under a risk-neutral measure , then the price at time of a zero-coupon bond maturing at time with a payoff of 1 is given by
where is the natural filtration for the process. The interest rates implied by the zero coupon bonds form a yield curve, or more precisely, a zero curve. Thus, specifying a model for the short rate specifies future bond prices. This means that instantaneous forward rates are also specified by the usual formula
Particular short-rate models
Particular short-rate models
Throughout this section represents a standard Brownian motion under a risk-neutral probability measure and its differential. Where the model is lognormal, a variable is assumed to follow an Ornstein–Uhlenbeck process and is assumed to follow .
One-factor short-rate models
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 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 observed market prices ("calibration"). This problem is overcome by allowing the parameters to vary deterministically with time.[2][3] In this way, 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. The implementation is usually via a (binomial) short rate tree [4] or simulation; see Lattice model (finance)#Interest rate derivatives and Monte Carlo methods for option pricing.
Merton's model (1973) explains the short rate as : where is a one-dimensional Brownian motion under the spot martingale measure.[5]
The Vasicek model (1977) models the short rate as ; it is often written .[6]
The Rendleman–Bartter model (1980) explains the short rate as .[7]
The Cox–Ingersoll–Ross model (1985) supposes , it is often written . The factor precludes (generally) the possibility of negative interest rates.[8]
The Ho–Lee model (1986) models the short rate as .[9]
The Hull–White model (1990)—also called the extended Vasicek model—posits . In many presentations one or more of the parameters and are not time-dependent. The model may also be applied as lognormal. Lattice-based implementation is usually trinomial.[10][11]
The Black–Derman–Toy model (1990) has for time-dependent short rate volatility and otherwise; the model is lognormal.[12]
The Black–Karasinski model (1991), which is lognormal, has .[13] The model may be seen as the lognormal application of Hull–White;[14] its lattice-based implementation is similarly trinomial (binomial requiring varying time-steps).[4]
The Kalotay–Williams–Fabozzi model (1993) has the short rate as , a lognormal analogue to the Ho–Lee model, and a special case of the Black–Derman–Toy model.[15] This approach is effectively similar to “the original Salomon Brothers model" (1987),[16] also a lognormal variant on Ho-Lee.[17]
Multi-factor short-rate models
Multi-factor short-rate models
Besides the above one-factor models, there are also multi-factor models of the short rate, among them the best known are the Longstaff and Schwartz two factor model and the Chen three factor model (also called "stochastic mean and stochastic volatility model"). Note that for the purposes of risk management, "to create realistic interest rate simulations", these multi-factor short-rate models are sometimes preferred over One-factor models, as they produce scenarios which are, in general, better "consistent with actual yield curve movements".[18]
The Longstaff–Schwartz model (1992) supposes the short rate dynamics are given by where the short rate is defined as [19]
The Chen model (1996) which has a stochastic mean and volatility of the short rate, is given by [20]
Other interest rate models
Other interest rate models
The other major framework for interest rate modelling is the Heath–Jarrow–Morton framework (HJM). Unlike the short rate models described above, this class of models is generally non-Markovian. This makes general HJM models computationally intractable for most purposes. The great advantage of HJM models is that they give an analytical description of the entire yield curve, rather than just the short rate. For some purposes (e.g., valuation of mortgage backed securities), this can be a big simplification. The Cox–Ingersoll–Ross and Hull–White models in one or more dimensions can both be straightforwardly expressed in the HJM framework. Other short rate models do not have any simple dual HJM representation.
The HJM framework with multiple sources of randomness, including as it does the Brace–Gatarek–Musiela model and market models, is often preferred for models of higher dimension.
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