Rescorla–Wagner model

2013-11-07T10:51:49Z

131.111.185.74:

In [[financial mathematics]], the '''Hull–White model''' is a [[mathematical model|model]] of future [[interest rate]]s. In its most generic formulation, it belongs to the class of no-arbitrage models that are able to fit today's term structure of interest rates. It is relatively straightforward to translate the mathematical description of the evolution of future interest rates onto a [[Lattice model (finance)|tree or lattice]] and so [[interest rate derivative]]s such as [[bermudan swaption]]s can be valued in the model.

The first Hull–White model was described by [[John C. Hull]] and [[Alan White (economist)|Alan White]] in 1990. The model is still popular in the market today.

==The model==

===One-factor model===
The model is a [[short-rate model]]. In general, it has dynamics

:<math>dr(t) = (\theta(t) - \alpha(t) r(t))\,dt + \sigma\, dW(t)\,\!</math>

There is a degree of ambiguity amongst practitioners about exactly which parameters in the model are time-dependent or what name to apply to the model in each case.
The most commonly accepted hierarchy has

:''θ'' and ''α'' constant – '''the [[Vasicek model]]'''
:''θ'' has ''t'' dependence – '''the Hull-White model'''
:''θ'' and ''α'' also time-dependent – '''the extended [[Vasicek model]]'''

===Two-factor model===
The two-factor Hull–White model {{harvcol|Hull|2006|pp=657–658}} contains an additional disturbance term whose mean reverts to zero, and is of the form:

:<math>d\,f(r(t)) = \left [\theta(t) + u - \alpha(t)\,f(r(t))\right ]dt + \sigma_1(t)\, dW_1(t)\!</math>

where <math>\displaystyle u</math> has an initial value of 0 and follows the process:

:<math>du = -bu\,dt + \sigma_2\,dW_2(t)</math>

==Analysis of the one-factor model==
For the rest of this article we assume only <math>\theta </math> has t-dependence.
Neglecting the stochastic term for a moment, notice that the change in r is negative if r is currently "large" (greater than θ(''t'')/α) and positive if the current value is small. That is, the stochastic process is a [[mean reversion|mean-reverting]] [[Ornstein–Uhlenbeck process]].

θ is calculated from the initial [[yield curve]] describing the current term structure of interest rates. Typically α is left as a user input (for example it may be estimated from historical data). σ is determined via [[calibration]] to a set of [[caplet]]s and [[swaption]]s readily tradeable in the market.

When <math>\alpha</math>, <math>\theta</math> and <math>\sigma</math> are constant, [[Itô's lemma]] can be used to prove that

:<math> r(t) = e^{-\alpha t}r(0) + \frac{\theta}{\alpha} \left(1- e^{-\alpha t}\right) + \sigma e^{-\alpha t}\int_0^t e^{\alpha u}\,dW(u)\,\!</math>

which has distribution
:<math>r(t) \sim N\left(e^{-\alpha t} r(0) + \frac{\theta}{\alpha} \left(1- e^{-\alpha t}\right), \frac{\sigma^2}{2\alpha} \left(1-e^{-2\alpha t}\right)\right).</math>

where <math>N( \cdot ,\cdot )</math> is the [[normal distribution]].

==Bond pricing using the Hull–White model==

It turns out that the time-''S'' value of the ''T''-maturity [[discount bond]] has distribution (note the ''affine term'' structure here!)

:<math>P(S,T) = A(S,T)\exp(-B(S,T)r(S))\!</math>

where

:<math> B(S,T) = \frac{1-\exp(-\alpha(T-S))}{\alpha} \,</math>
:<math> A(S,T) = \frac{P(0,T)}{P(0,S)}\exp\left( \, -B(S,T) \frac{\partial\log(P(0,S))}{\partial S} - \frac{\sigma^2(\exp(-\alpha T)-\exp(-\alpha S))^2(\exp(2\alpha S)-1)}{4\alpha^3}\right) \,</math>

Note that their terminal distribution for ''P''(''S'',''T'') is [[log-normal distribution|distributed log-normally]].

==Derivative pricing==

By selecting as [[numeraire]] the time-''S'' bond (which corresponds to switching to the S-forward measure), we have from the [[fundamental theorem of arbitrage-free pricing]], the value at time 0 of a derivative which has payoff at time ''S''.

:<math>V(t) = P(t,S)\mathbb{E}_S[V(S)| \mathcal{F}(t)].\,</math>

Here, <math>\mathbb{E}_S</math> is the expectation taken with respect to the [[forward measure]]. Moreover that standard arbitrage arguments show
that the time ''T'' forward price <math>F_V(t,T)</math> for a payoff at time ''T'' given by ''V(T)'' must satisfy <math>F_V(t,T) = V(t)/P(t,S)</math>, thus
:<math>F_V(t,T) = \mathbb{E}_T[V(T)|\mathcal{F}(t)].\,</math>

Thus it is possible to value many derivatives ''V'' dependent solely on a single bond ''P''(''S'',''T'') analytically when working in the Hull–White model. For example in the case of a [[put option|bond put]]
:<math>V(S) = (K-P(S,T))^+.\,</math>

Because ''P''(''S'',''T'') is lognormally distributed, the general calculation
used for Black-Scholes shows that

:<math>{E}_S[(K-P(S,T))^{+}] = KN(-d_2) - F(t,S,T)N(d_1)\,</math>

where

:<math>d_1 = \frac{\log(F/K) + \sigma_P^2S/2}{\sigma_P \sqrt{S}}\,</math>

and

:<math>d_2 = d_1 - \sigma_P \sqrt{S}.\,</math>

Thus today's value (with the ''P''(0,''S'') multiplied back in) is:

:<math>P(0,S)KN(-d_2) - P(0,T)N(-d_1)\,</math>

Here σ<sub>''P''</sub> is the standard deviation of the
log-normal distribution for ''P''(''S'',''T''). A fairly substantial amount
of algebra shows that it is related to the original parameters via

:<math>\sqrt{S}\sigma_P
=\frac{\sigma}{\alpha}(1-\exp(-\alpha(T-S)))\sqrt{\frac{1-\exp(-2\alpha S)}{2\alpha}}\,</math>

Note that this expectation was done in the S-bond measure, whereas we did not specify a measure at all for the original Hull-White process. This does not matter — the volatility is all that matters and is measure-independent.

Because [[interest rate caps/floors]] are equivalent to bond puts and calls respectively, the above analysis shows that caps and floors can be priced analytically in the Hull–White model. [[Jamshidian's trick]] applies to Hull-White (as today's value of a swaption in HW is a [[monotonic function]] of today's short rate). Thus knowing how to price caps is also sufficient for pricing swaptions.

The swaptions can also be priced directly as described in Henrard (2003). The direct implementation is usually more efficient.

==Trees and lattices==
However, valuing vanilla instruments such as caps and swaptions is useful primarily for calibration. The real use of the model is to value somewhat more [[exotic derivatives]] such as [[bermudan swaption]]s on a [[Lattice model (finance)|lattice]], or other derivatives in a multi-currency context such as Quanto Constant Maturity Swaps, as explained for example in Brigo and Mercurio (2001).

==See also==
*[[Vasicek model]]
*[[Cox–Ingersoll–Ross model]]
*[[Black-Karasinski model]]

==References==

'''Primary references'''
*John Hull and Alan White, "Using Hull-White interest rate trees," Journal of Derivatives, Vol. 3, No. 3 (Spring 1996), pp 26–36
*John Hull and Alan White, "Numerical procedures for implementing term structure models I," Journal of Derivatives, Fall 1994, pp 7–16
*John Hull and Alan White, "Numerical procedures for implementing term structure models II," Journal of Derivatives, Winter 1994, pp 37–48
*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.
*John Hull and Alan White, "One factor interest rate models and the valuation of interest rate derivative securities," Journal of Financial and Quantitative Analysis, Vol 28, No 2, (June 1993) pp 235–254
*John Hull and Alan White, "Pricing interest-rate derivative securities", The Review of Financial Studies, Vol 3, No. 4 (1990) pp. 573–592

'''Other references'''
*{{cite book |last= Hull|first= John C.|authorlink= John C. Hull|title= Options, Futures, and Other Derivatives|edition= 6th|year=2006 |publisher= [[Prentice Hall]] |location= [[Upper Saddle River, New Jersey|Upper Saddle River, N.J]] |isbn= 0-13-149908-4 |oclc= 60321487 |pages= 657–658 |chapter= Interest Rate Derivatives: Models of the Short Rate |ref=harv |lccn= 2005047692 }}
*{{cite book | title = Interest Rate Models — Theory and Practice with Smile, Inflation and Credit| author = [[Damiano Brigo]], [[Fabio Mercurio]] | publisher = Springer Verlag | year = 2001 | edition = 2nd ed. 2006 | isbn = 978-3-540-22149-4}}
*Henrard, Marc (2003). Explicit Bond Option and Swaption Formula in Heath-Jarrow-Morton One Factor Model, ''International Journal of Theoretical and Applied Finance'', 6(1), 57-72. [http://ssrn.com/abstract=434860 Preprint SSRN].
*Henrard, Marc (2009). Efficient swaptions price in Hull-White one factor model, arXiv, 0901.1776v1. [http://arxiv.org/abs/0901.1776 Preprint arXiv].
*Eugen Puschkarski, [http://web.archive.org/web/*/www.angelfire.com/ny/financeinfo/Diplomnew.ppt ''Implementation of Hull-White´s No-Arbitrage Term Structure Model''], Diploma Thesis, Center for Central European Financial Markets
*Letian Wang, [http://letianwang.net/Fixed_Income/09_Hull-White_Model.htm ''Hull-White Model''], Fixed Income Quant Group, DTCC (detailed numeric example and derivation)

'''Online utilities'''
*[http://lombok.demon.co.uk/financialTap/interestrates/hwtrinomialtree Hull-White Trinomial Tree], Dr. S.H. Man, Turaz.
*[http://lombok.demon.co.uk/financialTap/montecarlo/hullwhite Short Rates Simulation using Hull White Model], Dr. S.H. Man, Turaz.

{{Bond market}}
{{Stochastic processes}}

{{DEFAULTSORT:Hull-White model}}
[[Category:Finance theories]]
[[Category:Mathematical finance]]
[[Category:Interest rates]]
[[Category:Fixed income analysis]]
[[Category:Short-rate models]]

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Rescorla–Wagner model