AreInterestRateChangesNormalorLognormal?

YesandNo

AreInterestRateChangesNormalorLognomal?

YesandNo
RichTanenbaum
Savvysoft

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Table of Contents
Introduction................................................................................................................................................3
Buckettest..................................................................................................................................................3
Chisquaretest............................................................................................................................................4
Nottoobigtofail........................................................................................................................................5
Comparisontostocks..................................................................................................................................6
Blendedmodel............................................................................................................................................6
Shouldyoucare?Yes..................................................................................................................................7
Anevenbetterwaytogenerateinterestratescenarios............................................................................7
Conclusion...................................................................................................................................................8

AreInterestRateChangesNormalorLognormal?YesandNo
3

Introduction

Optionmodelsarederivedaftermakingseveralassumptions.Often,onespeaksabouttheclassicBlack
Scholesassumptionsoflognormalpricemovements,knownandconstantvolatility,borrowingand
lendingattheriskfreerate,notransactioncosts,notaxes,continuoustrading,etc.Butmodelsare
meanttobesimplificationsofreality:robustenoughtobeusedforaparticularpurpose,andsimple
enoughtounderstand,explaintoothers,codecorrectly,andidentifythecorrectinputvalues.
Intheequityworld,mostmodelsassumestockpricesarelognormallydistributed,andtheBlackScholes
formulawasintendedforpricingstockoptions.Butithasbeenusedinnearlyallothermarkets.The
lognormalassumptionisgenerallyusedwhenitisbelievedtheunderlyingassetpricecannotgobelowzero.
Whenthemodelisappliedtointerestrateoptions,theunderlyingassetisthebondyield,andthelognormal
assumptionwasconsideredappropriatesinceinterestratescouldntbenegative.Couldntbe,thatis,until
theywere.
Withlowandnegativeratesbecomingmorecommon,modelersneededtorethinktheunderlyingstochastic
processbehindinterestratemoves.Whichisallwellandgood,exceptthatitisimportanttomakesurethat
themodelfitsrealitywhereverpossiblewithoutoverlycomplicatingthemodel.Thus,whileitmaybe
convenientforamodelertoassumeratesarenormalinsteadoflognormaltoallowforthepossibilityof
negativerates,itneedstobetested.Acursoryglanceoftheliterature(meaningtwopagesofGoogleresults)
showsalmostnopapersaddressingthissubject,sowedecidedtodoourownresearchtoseewhichfit
historicaldatabetter:normalorlognormal.

Buckettest

Welookedat14yearsofdailydata,frommid2002tomid2016,specificallythreemonthUSLIBORandthe
2,5,10and30yearUSswaprates,allprovidedbyBloomberg.Thefirsttestwastoputallthedailychanges
intobucketsbasedoninterestratelevel,in50basispointincrements.ThusforthreemonthLIBORthefirst
bucketwasratesfrom0to50bp,thenextonewas50bpto1%,then1%to1.5%,etc.Thedailychangemade
itintoabucketiftheratefellintothatbucketforeachofthetwodays,sodayswheretheratecrossed
betweenbucketsfromonedaytothenextwerethrownout.Wealsoonlykeptabucketintheanalysisifit
hadatleast30datapoints.
Thestandarddeviationofthechanges(rateondayn+1minusrateondayn)wasthencalculatedforeach
bucket.Ifratechangeswerenormal,wewouldexpectthestandarddeviationtoberoughlythesameineach
bucket,asthestandarddeviationwouldnotbeafunctionoftheratelevel.Iftheratechangewere
lognormal,wewouldexpectthestandarddeviationtobeproportionaltotheaveragerateineachbucket.
Herearetheresults:

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Eachpairofrowsrepresentsdataforonerate(.25isthreemonthLIBOR).Eachcolumnisabucketbasedon
therate.Thefirstrowineachpairisthestandarddeviationofthechanges,where.0031is31basispoints
perday.Thesecondrowisthatstandarddeviationdividedbythemidpointrateinthatbucket.Aswesee,for
eachswapandLIBOR,thestandarddeviationdoesrisewithhigherlevelsoftherate,thoughinthetop
bucketsthestandarddeviationgoesdown,butitisstillhigherthanthestandarddeviationcalculatedforthe
lowestbucket.Asitturnsout,thehighestbucketsarefrom2006and2007exclusively,whenformanydays
theratedidnotchangeatall.Wasthisthecalmbeforethe2008storm?Thatsforanotherpaper.
Again,inthesecondrowweshowthestandarddeviationasafunctionoftheratelevel,wherewedividethe
basispointstandarddeviationbythemidpointofthebucketrangeforthatratelevel.Whilethesenumbers
arenotallexactlythesame,theyaremuchmoresimilarthanthestandarddeviationsoftheabsolute
changes.Inthelasttwocolumnsofthetableweshowthestandarddeviationofthestandarddeviationsin
thepriorcolumns,andseethatthesecondrowalwayshasasignificantlymoresimilarsetofnumbers.This
suggeststheratesareclosertolognormalthantonormal.

Chisquaretest

AmorerigorouschisquaretestwasalsoperformedoneachswapandLIBOR.Fortybucketswerecreated,
andwecomparedthefrequencyoftheabsolutechangestotheexpectedfrequenciesfromanormal
distribution.Wealsocomparedthefrequencyofthenaturallogoftheratioofconsecutiveratestothe

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AreInterestRateChangesNormalorLognormal?YesandNo
5

normaldistribution.Theresultswere:

Forfortybuckets,allofthesefailthechisquaretest(thenumberswouldneedtobelessthanabout54to
pass).Butwhichprocessbettermatchesthedataisabitlessclear:thelognormalresultisasmaller
differencefromthebaselinedistributionthanthenormalforthefirsttwomaturities,againsuggestingthose
ratesaremorelognormalthannormal,theyarebothequallygoodorbadforthe5year,whileforthetwo
longestmaturitiesthenormallookscloser.Giventheupwardslopeoftheyieldcurve,thiscanbeinterpreted
twoways:(1)shorterratesarelognormalandlongerratesarenormal,or(2)lowratesarelognormaland
highratesarenormal.Thesecondwayistheoppositeofhowmodelershavedealtwiththeproblemof
negativerates,whichistoassumetheyarenormalwhenratesarelowtogivethemamathematicalchance
ofgoingbelowzero.Butaplausiblewaytoexplainthesecondpossibilityistonotethataprocesswhich
becomesmorenormalwhenratesrisewillhavealowerprobabilityofskyrocketingrates.

Nottoobigtofail

Ineverycase,agraphofthedistributionsshowswhytheyfail.Heresthe10yearswaprateforlognormal
changes:

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Theobserveddistributionhasatallpeakaroundthemeanandfattertailsthananormalbellshapedcurve
(theoddeffectoftheleftmostandrightmostvaluesoftheobservedfrequenciesrisinghigherthantheir
neighborsisanartifactofthewaythechisquarewascalculated,wheretherecommendationistomakesure
thereareatleastfiveexpectedresultsineachbin.Thismeanstheentireextremepartofeachtailislumped
togetherintoasinglebin).Thistypeofdistributionisleptokurtic,andhasbeenobservedinthestockmarket
forover100years,butdespitethisthestandardpracticehasbeentoassumethestockmarketisclose
enoughtolognormaltocontinueusingit.

Comparisontostocks

Butarethestockreturnslessleptokurticthaninterestrates?WelookedatApplestockoverthesame14year
period,andthechisquarevaluefornormalwascalculatedtobe3250andforlognormalitwas362.Thus,
whilethedifferencebetweennormalandlognormalismorepronouncedinequities,thelognormalchi
squarevaluesforratesareverysimilartoequities,makingtheassumptionforlognormalityforratesjustas
goodasitisforstocks.

Blendedmodel

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AreInterestRateChangesNormalorLognormal?YesandNo
7

Returningtothepossibilitythatratesarelognormalatlowlevelsandnormalathighlevels,andablendof
thetwoinbetween,wetestedamodelwherethenominalrateisthesumoftwocomponents,onenormal
andonelognormal.Thepercentageoftheratethatislognormalwecallfactor,partnormalandpart
lognormal,withfactorrepresentingthepercentagethatislognormal.Wewillassumeforsimplicitythateach
ofthetwohavethesamevolatility,meaningiftherateisrandthenormalvolatilityisbbasispointsperday
whentherateispurenormal,thenthelognormalvolatilityisb/r.Forexample,iftherateis2%then20bpof
normalvolmeans10%lognormalvol.
Everydaythefactorwassetto:
1 current_rate / ratecross
Whereratecrossisanumberwhichrepresentstwicethe50/50point,andthepointabovewhichratesare
purenormal(anoverrideissettokeepfactorintherangeof0to1).
Basedontheratevolatilityandratecross,foreachhistoricaldatewecalculatedwhatsigmaeventoccurred
thatdaytocausetheobservedriseorfallinrates,withsigmabeingthenumberofstandarddeviationsthe
movewasforthatday.Ifthemodelisgood,thefrequencydistributionofthesesigmaswillbeclosetoa
normalcurve.Thechisquaretestwasusedhere,aswell.Thevalueforfortybinsis222,whichstillfailsthe
chisquaretest,butitisquiteabitlowerthaneitherthelognormalorthenormalreturned.Thissuggeststhat
itisanimprovementtomodelratesasachangingblendofnormalandlognormal,changinginadeterministic
wayastheratemovesupanddown.

Shouldyoucare?Yes

Theimplicationsofthisarewidespread.Asmentionedearlier,optionmodelsshouldreflectthefindingthat
ratesarenotnormallydistributedwhentheyarenearzero.Butbeyondoptionpricing,theseresultsalso
impactriskmanagementandriskmeasurement.Anytypeofscenarioanalysiswillneedtoreflectaltered
probabilitiesoflargeratemoves,andcalculationssuchasCVAandxVAwhichforecastratelevelsfarintothe
futurewillbehighlydependentuponthesefindings.Eventhegovernmentsrequiredstresstestsshould
reflecttheseempiricalresults.

Anevenbetterwaytogenerateinterestratescenarios

Evenwiththeblendingofthenormalandlognormalbasedonratelevels,westillendupwithaleptokurtic
distribution,whichcanmakethewholeanalyticalprocesssuspect.Inthecaseofscenariogenerationand
xVA,theuserorinstitutioncansimulateusingtheactualhistoricaldatainsteadofusingarandomnumber
generatorandthenapplyingtherandomnumberstoanunknowndistribution.Thistypeofbacktesting
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makesnodistributionalassumptions,andhastheaddedadvantagethatwhenyouarelookingatmorethan
onetimeseriestodrivethesimulationthecorrelationsbetweentheseriesdoesnotneedtobeestimatedor
anyspecialworkdonetoensureconsistentresults.
Inotherwords,generatingscenariosbyrandomlypickingadateinthepast,andusingtheratechangefor
thatdayfromthepreviousday(orpreviousweek,ormonth,orwhatever),thendoingthatagain,overand
over,samplingwithreplacement,willyieldthemostaccurateresultsbecauseitusesalltheactualobserved
rateschanges,eachoccurringwiththeproperfrequency,therebyguaranteeingweareusingthecorrect
distribution,evenifwedontknowwhattocallthatdistribution.Thesimulationwillthereforehavethepeak
inthemiddleandthefattailsbyconstruction.

Conclusion

Thequestionofhowinterestratesmoveisimportantandhasfarreachingimplications.Twocommonways
tomodelratesarethenormalandlognormalmodels.WetestedratemovementsforUSLIBORandswaps
overthepast14yearstoseewhichofthetwobetterdescribedreality,andfoundthatthelognormalmodel
usuallywasabetterfitofthedata,thoughtheybothfailthechisquaretestexhibitingleptokurtosis,witha
centralpeakandfattails(wesawthatApplestockalsohadthisproblem).Wealsoproposedanothermodel
whichsaystheratemovesareacombinationofthetwo,andthisperformedbetter,thoughitwasstill
leptokurtic.Wethenpointedoutthatforgeneratingratescenariosforriskmanagement,xVAandwherever
elseitispossible,itsbesttousetherealtimeseriesofratesandthususetheactualdistributioninsteadof
anapproximation.

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