Coping with Negative Short-Rates
Wilmott Magazine 2016(81) (2016) 58-68
30 Pages Posted: 10 Feb 2015 Last revised: 25 Jan 2016
Date Written: August 7, 2015
We discuss a simple extension of the Ho and Lee model with generic time-dependent drift in which: 1) we compute bond prices analytically; 2) the yield curve is sensible and the asymptotic yield is positive; and 3) our analytical solution provides a clean and simple way of separating volatility from the drift in the short-rate process. Our extension amounts to introducing one or two reflecting barriers for the underlying Brownian motion (as opposed to the short-rate), which allows to have more realistic time-dependent drift (as opposed to constant drift). In our model the spectrum -- or, roughly, the set of short-rate values contributing to bond and other claim prices -- is discrete and positive. We discuss how to calibrate our model using empirical yield data by fitting three parameters and then read off the time-dependent drift.
Keywords: Short-rate models, Ho and Lee model, time-dependent drift, volatility, bond prices, bond option prices, reflecting barriers, Brownian motion, Neumann boundary conditions, Schrodinger equation, yield
JEL Classification: G00
Suggested Citation: Suggested Citation