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Interest Rate Modeling Page last updated 13/01/2009
Nelson Siegel Yield Curve Model
Nelson Siegel Yield Curve Model with Svensson 1994 Extension
OneFactor Interest Rate Models (Vasicek. Cox, Ingersoll & Ross)
Interest Rate Trinomial Tree Hull & White Method
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NelsonSiegel Yield Curve Model »download NEW: Nelson & Siegel with Svensson 1994 extension
The idea of the NelsonSiegel (N&S) approach is to fit the empirical form of the yield curve with a prespecified
functional form of the spot rates which is a function of the time to maturity of the bonds (see below).
The Excel model does not just illustrate the model but, as an illustrative example, fits a term structure of spot rates
to the small universe of NZ Government bonds. This can in turn be used to detect over, respectively underpriced bonds.
(See other examples of bond relative value models on this website)
The Excel workbook uses SOLVER, the built in optimization module. There are some installation requirements
given in the file to run SOLVER and also macros using SOLVER. The N&S parameters are found by minimizing the sum of
squared differences between model and market prices. A more sophisticated version weighs these differences with
the inverse of the duration as proposed in Bliss (1998).
Illustration of MS Excel model
References:
Nelson, C. R. & Siegel, A. F. (1987). Parsimonious modeling of yield curves, Journal of Business 60(4): 473—489.
Bliss, R. R. (1997). Testing Term Structure Estimation Methods. Advances in Futures and Options Research(9), 197231.
Formulas from Van Landschoot, Astrid. The Term Structure of Credit Spreads on Euro Corporate Bonds. Working Paper, CentER,
References:
Nelson, C. R. & Siegel, A. F. (1987). Parsimonious modeling of yield curves, Journal of Business 60(4): 473—489.
Bliss, R. R. (1997). Testing Term Structure Estimation Methods. Advances in Futures and Options Research(9), 197231.
Formulas from Van Landschoot, Astrid. The Term Structure of Credit Spreads on Euro Corporate Bonds. Working Paper, CentER,
Tilburg University. April 2003. Downloaded from http://ideas.repec.org/p/dgr/kubcen/200346.html February 2004.
Note that the formula in this paper has a small typo and just shows the basic Nelson & Siegel where t2 = t1 .
NelsonSiegel Yield Curve Model with Svensson 1994 Extension »download
Svensson (1994) extend NelsonSiegel (1987) model described above with b 3 parameter term.
References:
Svensson, L. (1994). Estimating and interpreting forward interest rates: Sweden 19924.
Discussion paper, Centre for Economic Policy Research(1051).
Anderson, N., Breedon, F., Deacon, M., Derry, A., & Murphy, G. (1996). Estimating and interpreting the yield curve.
Chichester: John Wiley Series in Financial Economics and Quantitative Analysis. Chapter 2.4.6, pgs. 3641.
OneFactor Interest Rate Models »download
Error in calculation of A (missing brackets) in CIR model fixed 26/10/05. Hint from Rafael Nicolas Fermin from the Richard Ivey School of Business, University of
Western Ontario
This model introduces to the wellknown stochastic onefactor interest rate models of Vasicek (1977) and Cox, Ingersoll, and Ross (1985)
which we call "CIR" in the following. There are three worksheets in this Excel file, "Simulation OneFactor Models" shows discrete versions
of
the two models so one gets a feel for their meanreverting nature of the stochastic processes.
Each time the spreadsheet is recalculated (press F9), a new time series series is generated. The two sheets "Term structure Vasicek/CIR
model" show the the term structure implied by the stochastic process for the spot rates for each model.
Note that Vasicek interest rate may actually become negative unlike CIR where the random term becomes increasingly smaller as the rate
approaches zero (multiplication with square root of r):
Vasicek discrete version CIR discrete version
with
r spot rate
s instantaneous standard deviation of short rate
a pullback factor
b longterm equilibrium of shortterm rates
Dt a small time increment
The pictures below show how rates will be distributed in the very longrun, i.e. their probability distribution after the effect of the initial spot
rate r at t=0 has vanished. Both distributions have a mean of b (the longterm equilibrium). Yet under Vasicek they are normally distributed
and so there is a probability for them being negative. For the CIR model this density function has the property of a Gamma distribution, not
allowing for negative interest rates.
References:
Vasicek, O. 1977 "An Equilibrium Characterization of the term structure." Journal of Financial Economics 5: 177188.
Cox, Ingersoll, and Ross. "A Theory of the Term Structure of Interest Rates". Econometrica, 53 (1985). 385407.
Hull, John C., Options, Futures & Other Derivatives. Fourth edition (2000). PrenticeHall. P. 567f
Interest Rate Trinomial Tree Hull & White Method »download
Update 17 August 2005: removed an error in normal model in the calculation of alpha thanks to a hint from
Ricard Caballero Montesso, a specialist in financial mathematics and in particular interest rate models.
This model presents the general treebuilding procedure as proposed by Hull and White for a more general group of onefactor
models.
It handles spot interest rate processes that follow of the following general form:
With constants a (pullback factor of mean reversion
process) and s the volatility parameter of Wiener process
dz
At time t the process reverts to a level q(t)/a. q(t) is set to fit
for f(r) = r and f(r) = ln(r)
the current term structure of interest.
With constants a (pullback factor of mean reversion
process) and s the volatility parameter of Wiener process
dz
At time t the process reverts to a level q(t)/a. q(t) is set to fit
for f(r) = r and f(r) = ln(r)
the current term structure of interest.
It is a property of these models that they can be fitted to any term structure of interest.
Normal Model Lognormal Model
Below is a screenshot of the Excel/VBA model. Note the threshold factor 0.184 which was proposed by Hull & White to avoid
unnecessary sampling of unlikely interest rate scenarios. It basically determines the maximum number of interest rate steps in the
grid. Obviously the model as it stands now has limited practical use but it can now easily be extended to price interest rate sensitive
instruments like bonds and interest rate options. This is done by rolling the payoff of the instrument back trough the tree, discounting
at the interest rates determined at each node. To understand the basic idea, refer to Cox, Ross & Rubinstein Binomial Tree in this
website for an example of equity option valuation in a binomial tree.
Reference:
Adapted from Hull, John C., Options, Futures & Other Derivatives. Fourth edition (2000). PrenticeHall. p. 580.
Literature:
Hull, J. White, A. "Numerical Procedures for Implementing Term Structure Models I: Single factor models", Journal of Derivatives 2, 1 (1994), 716.
Hull, J. White, A. "Using HullWhite Interest Rate Trees", Journal of Derivatives, (Spring 1996), 2636.f
Send mail to kurthess@waikato.ac.nz with questions or comments about this web site.
Copyright © January, 2009 Kurt Hess, University of Waikato
Last modified: 13Jan2009