Black's Model of Interest Rates as Options, Eigenfunction Expansions and Japanese Interest Rates

30 Pages Posted: 13 Apr 2004

See all articles by Viatcheslav Gorovoi

Viatcheslav Gorovoi

Northwestern University - Department of Industrial Engineering and Management Sciences

Vadim Linetsky

Northwestern University - Department of Industrial Engineering and Management Sciences

Abstract

Black's (1995) model of interest rates as options assumes that there is a shadow instantaneous interest rate that can become negative, while the nominal instantaneous interest rate is a positive part of the shadow rate due to the option to convert to currency. As a result of this currency option, all term rates are strictly positive. A similar model was independently discussed by Rogers (1995). When the shadow rate is modeled as a diffusion, we interpret the zero-coupon bond as a Laplace transform of the area functional of the underlying shadow rate diffusion (evaluated at the unit value of the transform parameter). Using the method of eigenfunction expansions, we derive analytical solutions for zero-coupon bonds and bond options under the Vasicek and shifted CIR processes for the shadow rate. This class of models can be used to model low interest rate regimes. As an illustration, we calibrate the model with the Vasicek shadow rate to the Japanese Government Bond data and show that the model provides an excellent fit to the Japanese term structure. The current implied value of the instantaneous shadow rate in Japan is negative.

Suggested Citation

Gorovoi, Viatcheslav and Linetsky, Vadim, Black's Model of Interest Rates as Options, Eigenfunction Expansions and Japanese Interest Rates. Mathematical Finance, Vol. 14, pp. 49-78, January 2004. Available at SSRN: https://ssrn.com/abstract=513751

Viatcheslav Gorovoi (Contact Author)

Northwestern University - Department of Industrial Engineering and Management Sciences ( email )

Evanston, IL 60208-3119
United States

Vadim Linetsky

Northwestern University - Department of Industrial Engineering and Management Sciences ( email )

Evanston, IL 60208-3119
United States

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