Wednesday, January 21, 2015

short rate - Bond dynamics in Ho Lee model


The short rate in the Ho-Lee model is given by :


drt=(df(0,t)dt+σ2t)dt+σdWt


I'm trying to find the bond dynamics given by :


dP(t,T)/P(t,T)=rtdtσ(Tt)dWt


I started from :


P(t,T)=Et[eTtrsds]


and I applied Itô to the function P(t,T)=ϕ(t,r):


dϕ(t,r)=ϕ(t,r)tdt+ϕ(t,r)rdrt+122ϕ(t,r)r2(drt)2


I computed the derivatives :



ϕ(t,r)t=rtP(t,T)


ϕ(t,r)r=(Tt)P(t,T)


122ϕ(t,r)r2=(Tt)2P(t,T)


Assembling everything I get :


dP(t,T)/P(t,T)=rtdt(Tt)σdWt+[12(Tt)2σ2(Tt)(df(0,t)dt+σ2t)]dt


I don't know how to get rid of the last dt term. Any Help? Or did I get the derivatives wrong? I checked them several times but I don't see where the probem comes from. Thank you




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