An Elementary Introduction To Stochastic Interest Rate by Nicolas Privault

By Nicolas Privault

Rate of interest modeling and the pricing of comparable derivatives stay matters of accelerating significance in monetary arithmetic and threat administration. This ebook presents an obtainable advent to those themes by means of a step by step presentation of recommendations with a spotlight on specific calculations. each one bankruptcy is observed with workouts and their whole recommendations, making the booklet appropriate for complex undergraduate and graduate point scholars.

This moment variation keeps the most positive aspects of the 1st variation whereas incorporating a whole revision of the textual content in addition to extra routines with their recommendations, and a brand new introductory bankruptcy on credits hazard. The stochastic rate of interest types thought of diversity from common brief price to ahead price types, with a remedy of the pricing of comparable derivatives resembling caps and swaptions below ahead measures. a few extra complicated issues together with the BGM version and an method of its calibration also are coated.

Readership: complicated undergraduates and graduate scholars in finance and actuarial technology; practitioners inquisitive about quantitative research of rate of interest versions.

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Extra resources for An Elementary Introduction To Stochastic Interest Rate Modeling

Example text

1 we know that t ˆt := Bt + B ψs ds, 0 ≤ t ≤ T, 0 is a Brownian motion under Q. Let also t V˜t = Vt exp − t rs ds , and S˜t = St exp − 0 rs ds , 0 denote the discounted portfolio and underlying asset. 1. 10) February 29, 2012 15:49 24 World Scientific Book - 9in x 6in main˙privault An Elementary Introduction to Stochastic Interest Rate Modeling iii) we have t Vt = V0 exp t ru du + t ˆu , rs ds dB σu ηu Su exp 0 0 t ∈ R+ . 11) Proof. 11). e. 10) holds. 10) is satisfied we have t rs ds V˜t dVt = d exp 0 t t rs ds V˜t dt + exp = rt exp 0 rs ds dV˜t 0 t ˆt rs ds V˜t dt + σt ηt St dB = rt exp 0 ˆt = Vt rt dt + σt ηt St dB ˆt = ζt At rt dt + ηt St rt dt + σt ηt St dB = ζt dAt + ηt dSt , hence the portfolio is self-financing.

7) We will assume that the short rate (rt )t∈R+ has the expression t rt = g(t) + h(t, s)dBs , 0 where g(t) and h(t, s) are deterministic functions, which is the case in particular in the [Vaˇsiˇcek (1977)] model. 2) and Property (a) of conditional expectations, cf. Appendix A, we have P (t, T ) = IEQ e− = IEQ e− T t rs ds Ft T (g(s)+ 0s t h(s,u)dBu )ds = e− T t = e− T t g(s)ds = e− T t g(s)ds − t 0 T u∨t = e− T t g(s)ds − t 0 T t h(s,u)dsdBu = e− T t g(s)ds − t 0 T t = e− T t g(s)ds − t 0 T t g(s)ds IEQ e− T t s 0 IEQ e− T 0 T u∨t e e e e Ft h(s,u)dBu ds Ft h(s,u)dsdBu h(s,u)dsdBu Ft IEQ e− T t T u∨t h(s,u)dsdBu IEQ e− T t T u h(s,u)dsdBu h(s,u)dsdBu IEQ e− T t T u h(s,u)dsdBu h(s,u)dsdBu e2 1 T t ( T u Ft Ft 2 h(s,u)ds) du .

1. 10 ST-K>0 9 8 7 Strike St K=6 5 4 ST-K<0 3 2 S0=1 0 0 Fig. 8 T=1 Samples price processes simulated according to a geometric Brownian motion. On the other hand, if the trader aims at buying some stock or commodity, his interest will be in prices not going up and he might want to purchase a call option, which is a contract allowing him to buy the considered asset at time T at a price not higher than a level K fixed at time t. Here, in the event that ST goes above K, the buyer of the option will register a potential gain equal to ST − K in comparison to an agent who did not subscribe to the call option.

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