INTEREST

RATE MODELLING
By Jawwad Ahmed Farid

I N T E R E S T R A T E M O D E L L I N G

CONTENTS
INTEREST RATE MODELLING ......................................................................................................................... 5
1. INTRODUCTION .................................................................................................................................. 5
a. Equilibrium vs. No-Arbitrage models ....................................................................................... 6
b. One- factor vs. multiple-factor models .................................................................................... 6
2. BASIC CONCEPTS ................................................................................................................................ 6
a.
b.
c.
d.
e.
f.
g.
3.

Cash flows ................................................................................................................................ 6

Discounting Cash flows ............................................................................................................ 7
Spot Rates ................................................................................................................................. 7
Forward Rates .......................................................................................................................... 7
Short rates ................................................................................................................................ 8
Yield to Maturity ....................................................................................................................... 9
Term structure of interest rates ............................................................................................... 9
DERIVATION OF THE ZERO AND FORWARD CURVES .................................................................................... 10

a. Defining the Par Term Structure .............................................................................................. 10

Step 1: Select an appropriate term structure ..................................................................... 10
Step 2: Extending the term structure .................................................................................. 10
Step 3: Creating a default term structure ........................................................................... 11
b. Deriving the Zero Curve ........................................................................................................... 12
Step 1: Develop the cash flows matrix ................................................................................ 12
Step 2: Developing the discounted value of cash flows matrix and the zero curve ............ 12
c. Deriving the Forward Curve ..................................................................................................... 14
Step 1: Deriving forward rates ............................................................................................ 14
4. BUILDING EQUITIES, COMMODITIES, CURRENCIES & INTEREST RATE MONTE CARLO SIMULATORS IN EXCEL .......... 15
a.
b.
c.
d.
e.

What is a Monte Carlo Simulator ............................................................................................. 16

The process or generator function for the MC simulator a first pass ................................... 16
Building your first Monte Carlo (MC) Simulator model ............................................................ 17
Extending MC simulation models to Currencies & Commodities ............................................ 19
MC Simulations models Understanding drift and diffusion and volatility drag ..................... 19
The Zero Drift, Zero Diffusion case ..................................................................................... 20
The Unit Drift, Zero Diffusion case ...................................................................................... 21
The Zero Drift, Unit Diffusion case ...................................................................................... 21
The Unit Drift, Unit Diffusion case ...................................................................................... 22
Understanding Volatility drag or sigma2 (squared) ......................................................... 22
f. Linking Monte Carlo Simulation with Binomial Trees and the Black Scholes model ................ 23
g. Simulating Interest rates using CIR and HJM ........................................................................... 24
5. ONE-FACTOR MODELS ......................................................................................................................... 25
a. Cox Ingersoll Ross (CIR) Model ................................................................................................. 25
Estimating Parameters and Calibrating the CIR Model ....................................................... 26
Simulating future short term interest rates under the CIR Model ...................................... 27
Modelling longer term rates ............................................................................................... 28
b. Black Derman Toy (BDT) Model ............................................................................................... 28
How to Construct a BDT Model in Excel .............................................................................. 28
6. MULTIPLE FACTOR MODELS .................................................................................................................. 43

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I N T E R E S T R A T E M O D E L L I N G

a. PCA Analysis ............................................................................................................................. 43

i. The PCA Process- Overview .......................................................................................... 43
ii. How to conduct a Principal Component Analysis in Excel ........................................... 45
b. HJM Model ............................................................................................................................... 50
i. Structure of an HJM Interest Rate Model ..................................................................... 50
ii. How to construct an HJM interest Rate Model in Excel .............................................. 50
7. MONTE CARLO SIMULATION APPLICATION: FORECASTING MONETARY POLICY RATE DECISION FOR PAKISTAN ........ 54
a. Process ..................................................................................................................................... 54
b. Results ...................................................................................................................................... 56
Step 1: Simulating Crude Oil Prices ..................................................................................... 56
Step 2: Calculating Imports ................................................................................................. 56
Step 3: Simulating Exports .................................................................................................. 56
Step 4: Simulating Remittances .......................................................................................... 57
Step 5: Calculating the change in Net Foreign Assets (NFA) ............................................... 57
Step 6: Calculating M2 and M2 Growth .............................................................................. 57
Step 7: Forecasting Core Inflation ....................................................................................... 58
Step 8: Calculating the cut in the policy discount rate ........................................................ 58
BIBLIOGRAPHY .......................................................................................................................................... 59
DISCLAIMER .............................................................................................................................................. 60

Please do not photocopy or distribute without permission. All rights reserved Alchemy Software Pvt Limited.
http://FourQuants.com
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