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Continues Time Methods In Finance

Week 10: Interest Rate Derivatives

(see also Hull, Chapter 16; Wilmott, Chapter 35)

Lecture IX.1 Black’s Model

After we have finished with the ‘Greek alphabet’, let us move on to discuss a new class of
financial instruments called interest rate derivatives, that is, products whose payoffs
depend in some way on the level of interest rates. These instruments amount to a huge
chunk of all trades in financial derivatives, especially, in the over-the-counter markets. The
amusing thing about these products is that even within the same financial company there
may exist more than one model to price these derivatives. There is no consensus about
which model to use. Moreover, almost every month there appears a new model. In spite of
such a mess, it is still possible to observe that all pricing models fall into two main classes:
those with an underlying security (such as options) and those without an underlying asset
(‘pure’ interest rate derivatives).

The goal of the next two lectures is to introduce two categories of pricing methods used for
valuing interest rate derivative contracts and give examples of some products.

• The first category of pricing models considers the interest rate derivative on an
interest bearing security (usually bond) as an option on a share by assuming that the
underlying source of risk is the price of the underlying security or its yield.

• The second category deals with instruments on fixed income securities and the
securities themselves, as functions of the term structure of interest rates. This type
of derivatives is known as yield curve models, i.e., models that describe the
probabilistic behaviour of the yield curve over time. These products can also be
called “pure interest rate derivatives”, since they do not have an underlying asset.

We start with the first category of pricing models.

Limitations Of The BS Model

It is important to point out the differences between the assumptions of the BS world and
the conditions of a reasonable bond option-pricing model. There are four main differences,
which must be addressed when applying the BS model to bond option pricing:

1) The underlying bond usually pays a coupon. The coupon payment made on the
bond has a significant effect on the value of the bond option. The effect is similar to
the effect of a dividend on the value of a share option.
2) The underlying bond ages because of the fact that it has a stated maturity. The BS
model assumes that the price of the underlying security follows a lognormal
distribution. This implies that the distribution of the rate of return remains the same
through time. This assumption is not realistic for bonds, which have a known and
finite maturity. The ageing problem of the bond implies that the rate of return on
the bond is distributed with a variance which decreases through time, since
alternatively; the bond price must converge to par (or face value) at maturity. The
figure below shows how the uncertainty about the price of a share and a bond
changes as one looks further into the future:

Continues Time Methods In Finance

Standard Deviation of Price



Bond Maturity


In the case of a share, the uncertainty, as measured by standard deviation, increases,

as one looks further ahead. Whereas in the case of a bond, it first increases and then
decreases. There is no uncertainty at all about the bond’s price when it matures, since
its price must be equal to face value at this time. This is known as the pull to par

3) It is inconsistent to assume a constant financing rate (or cost of carry) and

stochastic bond prices. The uncertainty of bond prices originates from uncertainty
about the behaviour of the rate of interest through time. Applying the BS model to
the pricing of a bond is equivalent to assuming that the behaviour of the rate of
interest is known during the life of the option. This is equivalent to assuming that
the price of any default free bond, which has maturity shorter than the maturity of
the option, is constant. This assumption is not unrealistic when the maturity of the
option is short relative to the maturity of the underlying bond. However, this
becomes less realistic as the maturity of the option increases for a given maturity of
the underlying bond. The bond aging effect becomes important.
4) The bond option may be American. The fact that a bond option is an American
option is important when there is a high probability that the option will be exercised
before its expiration date. The probability of early exercise increases when:
• The option is a call option and the underlying bond pays coupon;
• The option is an in-the-money put in an environment where rates are expected
to decrease.
The importance of early exercise is increased by the ageing of the underlying bond
as the maturity of the option increases.

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Options On Bond Futures

The most popular exchange-traded interest rate derivatives are options on

various kinds of bonds, like US Treasury bond futures. For simplicity we consider a
European bond option on a bond B. The option gives the holder the right to buy or sell the
bond for a certain price E on a certain date T (in what follows, we will take the present
time t = 0).

The valuation of such a derivative is somewhat tricky. The appropriate pricing model was
proposed by Fisher Black in 1976, therefore, the model is called Black’s model. The
underlying of the option is the futures price of the bond, F. The main assumption of the
model is that the bond has a lognormal probability distribution at maturity date of the
option, like in the standard Black-Scholes model (therefore, these two models are, in fact,
very similar). The source of the bond price random behaviour comes from the uncertainty
in the interest rate. The above conditions are sufficient for using the risk-neutral valuation
method for pricing options on bond futures.

However, in this course, following the Black-Scholes approach, we put emphasize on

using differential equations in valuing financial derivatives. Therefore, it is important to
understand how the latter technique can be used for options on bond futures. Now I would
like to explain how this could be done.

The tricky point si that since we are valuing a European option, we do not care about the
values of B and F prior to the option maturity time T. We just require B to be log-normally
distributed at the option expiry date. This assumption will still stand, if we further assume
that during the life-time of the option, B follows a geometric Brownian motion:

dB = µ Bdt + σ BdW ,

with constant parameters µ and σ. Since, in reality, the bond value does not necessarily
follow geometric Brownian motion, the variable σ is not strictly speaking a volatility. It is
nothing more than a parameter with the property that σ T is the standard deviation of

Now we can use the Black-Scholes equation. All we have to do is to replace the share S
with the bond spot price B. The futures on a bond with the spot price B is calculated using
the formula 1

F = (B – I)er(T - t),

Here we made a somewhat controversial assumption that the short-term interest rate is constant. Over short
time horizons most practitioners accept this, since the uncertainty of the bond value originates from the
random behaviour of the long-term interest rate associated with the maturity date of the bond (up to 30
years). Then, instead of the futures price, we can use the forward price of the bond.

Continues Time Methods In Finance

where I is the present value of the coupons that will be paid during the life of the option
and r is the zero-coupon yield for maturity T. You can find the corresponding BS equation
for the option in Lecture VII.2 of the lecture notes (options on futures).

Since we have reduced the problem to the BS equation, we can use the BS formula for the
option value. For a European call it is given as follows2

c = e -rT[F · N(d 1) – E · N(d2)].


ln( F / E ) + σ 2T / 2
d1 = ,
σ T
d 2 = d1 − σ T .

The value, p, of the corresponding put option is given by

p = e -rT[E · N(-d 2) – F · N(-d 1)].

The important point to be made is that since the interest rate is now considered as non-
stochastic, the futures price coincides with the forward bond price and is equal to the
expected spot price at maturity of the option. Therefore, the formula for call can be
rewritten in the following equivalent form

c = Present Value[Expected Value(B(T;T)) · N(d1) – E · N(d 2)].

Presented as above, the formula can be easily modified for the case when the payoff of the
option is made at time different from the maturity of the option. Assume that the payoff of
the option is calculated from the value of the bond B at time T but the payoff is delayed
until time T* where T*>T. In this case, the discounting to the present value has to be done
from time T* at the zero-coupon rate r*. That is,

c = e -r*T*[F · N(d 1) – E · N(d 2)],

p = e -r*T*[E · N(-d 2) – F · N(-d1)].

Now I would like to demonstrate how the Black’s model could be used for valuing a
particular type of interest rate derivatives – swaptions.

Example: European Swaptions

Swaptions are options on interest rate swaps. They give the holder the right to enter into a
certain interest rate swap at a certain time in the future. The underlying is the futures price
of the swap rate, which is very similar to the futures price of the bond.

If we didn’t assume that the short-term interest rate is constant, we would get the following answer for a
c = B(0;T)[F · N(d1) – E · N(d2)],

where B(0;T) is the bond spot price.

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Suppose a company knows that in six months it will enter into a five-year floating rate loan
agreement with resets every six months and knows that it will wish to swap the floating
interest payments for fixed interest payments to convert the loan into a fixed-rate loan.

At a cost, the company could enter into a swaption giving it the right to receive six-month
LIBOR (the London Interbank Offer Rate) and pay a certain fixed rate of interest, say 12%
per annum, for a five-year period starting in six months.

In six-months time there will be two possibilities:

1) The fixed rate on a regular five-year swap in six months turns out to be less than
12% p.a., then the company will choose not to exercise the swaption and will enter
into a swap agreement in the usual way.
2) The fixed rate turns out to be greater than 12% p.a., then the company will choose
to exercise the swaption and will obtain a swap at more favourable terms than those
available in the market.

Swaptions, when used in this way, provide companies with a guarantee that the fixed rate
of interest they will pay on a loan at some future time will not exceed some level.

There exist two types of swaptions:

• A payer swaption: it is the right to buy a swap, i.e., pay a fixed rate of interest and
receive floating.
• A receiver swaption: it is the right to sell a swap, i.e., pay floating and receive

A payer swaption will be exercised at maturity, if the swaption strike rate, the fixed rate
specified in the contract, is lower than the prevailing market fixed rate for swaps with the
same maturity. This is similar to the call payoff structure. The swaption can be closed out
by selling the low fixed rate swap obtained through the swaption for a gain, rather than
entering into that swap.

Similar reasoning applies to the decision to exercise a put swaption.

European swaptions are frequently valued assuming that the swap rate at the maturity of
the option is lognormal. Therefore, we can use the Black’s model for valuation of the

• Consider a payer swaption that gives the right to pay RE and receive floating on a
swap that will last n years starting in T years.
• Assume that there are m payments per year under the swap and that the principle is
• Suppose that the swap rate at the maturity of the swap option is R. Both R and RE
are expressed with a compounding frequency of m times per year.

The payoff from the swaption consists of a series of cash flows equal to

Continues Time Methods In Finance

max( R − R E ,0).

Here LR/m is the cash flow on a swap where the fixed rate is R and LRE/m is the cash flow
on a swap where the fixed rate is RE. At this point, you may have to refresh your memory
of discrete and continuous compounding, which we discussed at the beginning of this

The cash flows are received m times per year for the n years of the life of the swap. They
are received at times T + 1/m, T+2/m, … T + mn/m measured in years from today. Each
cash flow is the payoff from a call option on R with a strike price RE.

Let us denote ti = T + i/m, where i takes values from 1 to mn. Then using the Black
formula, we can obtain the value of the cash flow received at time ti:

L −r * t
e [ FN (d 1 ) − RE N ( d 2 )]
i i


ln( F / RE ) + 12 σT
d1 = , d 2 = d1 − σ T ,
σ T

where F is the forward swap rate and r*i is the continuously compounded zero-coupon
interest rate 3 for maturity of ti.

The total value of the swaption is given as the sum of all discounted cash flows:

∑ m
e −r* t [ FN (d 1 ) − RE N ( d 2 )] .
i i

i =1

This can be rewritten as follows

[ FN (d 1 ) − R E N (d 2 )]


A = ∑ e −r * t . i i

i =1

Note that A can be seen as the present value of an annuity whose first payment occurs at
time T + 1/m and continues until time T + mn/m.

Note that we are using discretely compounded rates for cash flows and continuously compounded rates for
discounting of these cash flows.

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For a receiver swaption, that gives the holder the right to receive a fixed rate of RE instead
of paying it, the payoff of the swaption is

max( RE − R ,0).

This is a put option on R. The value of the swaption can be found using the put-call parity:

[− FN (− d 1 ) + RE N (− d 2 )] .

The important point to be made is that the relevant volatility for the Black formula as
applied to swaptions is the volatility of the forward swap rate. Despite the fact that A is
itself a stochastic quantity, as long as one can hedge one’s position in the swaption using
the forward bond A, the volatility of A does not enter the valuation formula. So we can set
it to zero.

A Numerical Example

Suppose that the LIBOR yield curve is flat at 4% p.a. with continuous compounding.
Consider a European swaption that gives the holder the right to pay 5% in a three-year
swap starting in five years. The volatility measure for the swap rate is 20%. Payments are
made semi-annually and the principle is €100. Thus, we have
• r*i = 0.04
• RE = 0.05
• σ = 0.2
• L = €100
• T = 5 years

Since the swap is for three years, there will be six cash flows (remember that payments are
made every six months). Correspondingly, for the quantity A we get

A = e-0.04×5.5 + e-0.04×6.0 + e-0.04×6.5 + e-0.04×7.0 + e-0.04×7.5 + e-0.04×8.0 = 4.583.

Now we have to find the spot forward price of the spot swap rate. The latter is the LIBOR,
i.e., 4%. The forward rate is a semi-annually compounded rate. Therefore, we have to
convert the continuously compounded LIBOR into a semi-annually compounded forward.
We have to use the following formula

(1 + F/2)2 = er*.

We find

• F = 2(er*/ 2 – 1) = 4.583%.

Now we have to substitute all data into the Black formula:

Continues Time Methods In Finance

ln( 4 .04 / 5 ) + 12 0.2 2 × 5

d1 = ≈ 0.0289 ,
0.2 × 5
d 2 = 0.0289 − 0 .2 × 5 ≈ −0.4183 ,
100 × 4.583
Swaption = × [(0 .0458 ) × N ( 0.0289 ) − (0 .05 ) × N ( −0 .4183 )] = 1 .5
Thus, we have found that the European style call swaption is worth €1.5.

There are other interest rate derivatives, which can be valued using the Black’s model.
These include caps and spreads.

Continues Time Methods In Finance

Lecture IX.2 Yield Curve Derivatives

In the previous lecture we discussed contingent claims falling into the first category of
interest rate derivatives, that is, derivatives whose underlyings are interest-bearing
securities. Now I would like to talk about the second category of interest rate derivatives,
which are defined as functions of the yield curves. These instruments are not options and,
therefore, are more difficult to price because there is no underlying asset with which to

The Yield Curve

The main assumption of the BS world was that the interest rate is a known function. This is
an acceptable conjecture for short-dated derivative products such as options. But these
were exactly the type of derivatives that we were discussing so far. However, in the
financial markets options are not the only tradable derivatives. There are many other
products such as bonds, for instance. The latter are examples of long-dated instruments
with maturities spreading up to 30 years. In dealing with derivative products with a longer
lifespan, we must inevitably address the problem of random interest rates.

A measure of future values of interest rates, widely used by traders, is the yield curve. It is
defined as follows

ln( B (t; T ) / B(T ; T ))

Y (t; T ) = − ,
T −t

where t is the current time and B(t;T) is the present value of a zero-coupon bond with
maturity time T.

When the interest rate is constant, then

B(t;T) = B(T;T)e-r(T – t).

In this case, the yield function Y(t;T) is constant and coincides with the interest rate:

Y = r.

However, for a non-constant interest rate, the yield is not equal to r. The yield curve is the
plot of Y(t;T) against time to maturity T – t. The dependence of the yield curve on the time
to maturity is called the term structure of interest rates. The disadvantage of Black’s model
discussed in the previous lecture is that it doesn’t fit very well the observed in the market
term structure. As you remember, all we cared for was the bond price distribution function
at the expiration date of the option. However, many traders do not feel comfortable about
an instrument, which doesn’t fit into the market data. The interest rate derivatives
discussed in the present lecture, do not have this fault.

It is observed from market data that yield curves typically come in three distinct shapes,
each associated with different economic conditions:

Continues Time Methods In Finance


• Increasing – this is the most common form for the yield curve. Future interest rates
are higher than the short-term rate, since it should be more rewarding to tie money
up for a long time than for a short time;
• Decreasing – this is typical of periods when the short rate is high but expected to
• Humped – again the short rate is expected to fall.

The Valuation Of A Bond

Bonds fall into the second category of “pure derivatives”, simply, because they do not have
any tradable underlying. They are functions of interest rates. The random behaviour of
bonds values is due to unpredictable changes in interest rates. Since there is uncertainty
about the future course of the interest rate, it is natural to model it as a random variable . In
the same way that we proposed a model for the share price as a lognormal random walk, let
us suppose that the interest rate r follows Brownian motion described by a stochastic
differential equation of the form

dr = u(r,t) dt + w(r,t) dW.

The functional forms of u(r,t) and w(r,t) determine the behaviour of the spot rate. The latter
is the interest rate for the shortest possible deposit. I will use this Brownian motion to
derive a partial differential equation for the price of a bond. The derivation will be very
similar to the way we derived the BS equation. When interest rates follow the stochastic
differential equation written above, a bond has a price of the form B(r,t); the dependence
on the maturity date T will be made explicit only when necessary.

Valuing a bond is technically more difficult than pricing an option, since there is no
underlying asset with which to hedge: one cannot go out and ‘sell’ an interest rate of 4.5%.
However, we have already learnt before that we always can hedge one derivative with

Continues Time Methods In Finance

another derivative. In this particular case of bonds, as the second derivative, we can choose
a bond with a different maturity date. For this reason we set up a portfolio containing two
bonds with different maturities, T1 and T2. The bond with maturity T1 has value B1 and the
bond with maturity T2 has value B2.We hold one of the former and short a quantity ∆ of the

Π = B1(r,t;T1) - ∆B2(r,t;T2).

The change in this portfolio in a time interval dt can be found by using Ito’s lemma:

∂B1 ∂B1 2 ∂ B1
 ∂ B2 ∂B2 2 ∂ B2

dΠ = dt + dr + 2 w
1 
dt − ∆  dt + dr + 2 w
dt .
∂t ∂r ∂r 2
 ∂t ∂r ∂r 2

We can see that the random component in dΠ can be completely eliminated if we choose
the delta as follows:

∂ B1
∆ = ∂r ∂B2 .

Once we have eliminated all risk in the portfolio, it must give us return at the risk-free rate,
i.e., the spot rate. Otherwise, there would be an arbitrage opportunity. Thus, the change in
the portfolio must obey the following equation

d Π = rΠ dt.

In the last equation, gathering together all B1 terms on the left-hand side and all B1 terms
on the right-hand side, we find that

 ∂ B1 1 2 ∂ 2 B1  ∂B1  ∂ B2 1 2 ∂ 2 B2  ∂B 2
 +2w − rB1  =  +2w − rB2  .
 ∂t ∂r ∂r  ∂t ∂r ∂r
2 2
 

This is one equation in two unknowns, B1 and B2. However, the left-hand side is
a function of T1 but not T2, and the right-hand side is a function of T2 but not T1. The only
way for this to be possible is for both sides to be independent of the maturity date. Thus,
we can drop the subscript from B and write

 ∂B 1 2 ∂ 2 B  ∂B
 +2w − rB  = a( r, t )
 ∂t ∂r ∂r

for some function a(r,t), which will be explained in a moment. We can always present
a(r,t) in the form

Continues Time Methods In Finance

a(r,t) = w(r,t)λ(r,t) – u(r,t),

where we simply switched one unspecified function, a(r,t), for another, λ(r,t).

Then, the zero-coupon pricing equation takes the following form

∂B 1 2 ∂ 2 B ∂B
+2w + (u − λw) − rB = 0 .
∂t ∂r 2

In order to solve this equation uniquely, we must impose appropriate boundary conditions.
One condition corresponds to the payoff on the maturity date and so

B(r,T) = Z,

where Z is the face value of the bond or B(T;T). Other boundary conditions depend on the
form of u(r,t) and w(r,t).

When the bond pays continuously coupon K, then the pricing equation takes the following

∂B 1 2 ∂2 B ∂B
+2w + (u − λ w) − rB + K = 0 .
∂t ∂r 2

The Market Price Of Risk

There exists a very elegant interpretation of the mysterious function λ(r,t), which was
introduced above. Let us again consider the change in the bond value in a time step dt:

∂B  ∂B 1 2 ∂ 2 B ∂B 
dB = w dW +  + 2w +u dt.
∂r  ∂t ∂r 2
∂ r 

Using the pricing equation, we can present the above change in the following form

∂B  ∂B 
dB = w dW +  wλ + rB dt,
∂r  ∂r 


dB − rBdt = w (dW + λdt ).

The presence of the random increment dW shows that this is not a risk-less change. The
deterministic term may be understood as the excess return above the risk-free rate for
taking a certain level of risk. As a compensation for accepting the extra risk the portfolio
profits by an extra gain proportional to λ dt per unit of risk, dW. For this reason, this
function is often called the market price of risk.

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For shares, one can show that the market price of risk is

µ −r
λS = ,

where µ and σ are the drift and the volatility of a share, respectively. From Black-Scholes
we know that neither λ nor µ show up in the equation. This is because of the risk-
neutrality. It turns out that in pricing bonds, we also have to use not the real random
variable with the drift u, but the risk-neutral spot rate with a drift u - λw, that is,

dr =(u - λw) dt + w dW.

Examples Of Random Walks

Because of the presence of the functions u(r,t), w(r,t) and λ(r,t), the pricing equation for
the second category of interest derivatives is very hard to solve exactly. These functions
are fixed by fitting a theoretical model into the observed yield curve. There have been
found only a very few examples, when the solution can be obtained in a close form.

The equation can be solved exactly, if the interest rate follows one of the two random

• (The Hull and White model) dr = (θ(t) - ϕ(t)r)dt +σ(t)dW. This fits current yield
curve, all current spot rate volatilities and all future short-rate volatilities;
• (The Cox, Ingersoll and Ross model) dr = γ (θ − r ) dt + σ r dW . This has some of
the propertie s of the HW model, but the stochastic term has a standard deviation
proportional to the square root of the spot rate. This means that as the short-term
interest rate increases, its standard deviation increases.

In the CIR model, γ, θ and σ are constant parameters. The HW model is a generalisation of
the Vasicek model with constant parameters. Unfortunately, even in these two cases, the
solutions are too complicated to be analysed in this course.

In most of the other cases, solutions can be found only using various numerical methods.
However, their discussion goes beyond the scope of this course.

Whenever, the solution of the bond pricing equation is known, one can consider options on
bonds. These instruments fall into the first category of interest rate derivatives and their
pricing methods can be adopted from the previous lecture.

Try To Answer The Following Questions

1) What are the two categories of interest rate derivatives?

2) What are the main assumptions of Black’s model for pricing options on bonds?
3) What is a swaption? What is its payoff?

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4) What is the pricing formula for bonds?

5) Can you explain what the market price of risk is?

Continues Time Methods In Finance