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

Authors

  • Viatcheslav Gorovoi,

    1. Department of Industrial Engineering and Management Sciences, McCormick School of Engineering and Applied Sciences, Northwestern University
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  • Vadim Linetsky

    1. Department of Industrial Engineering and Management Sciences, McCormick School of Engineering and Applied Sciences, Northwestern University
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  • This research was supported by the U.S. National Science Foundation under grant DMI-0200429.

  • Manuscript received March 2002; final revision received October 2002.

Address correspondence to Vadim Linetsky, Department of Industrial Engineering and Management Sciences, McCormick School of Engineering and Applied Sciences, Northwestern University, 2145 Sheridan Road, Evanston, IL 60208; e-mail: linetsky@iems.nwu.edu.

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.

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