Coping with Negative Short-Rates
Zura Kakushadze
Quantigic Solutions LLC; Free University of Tbilisi
August 7, 2015
Abstract:
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.
The paper is available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2562500
