1 The Mean Field of the Sun Leif Svalgaard Stanford University Sept. 2, 2011.
Solving the Vasicek model for reversion to the mean of...
Transcript of Solving the Vasicek model for reversion to the mean of...
Solving the Vasicek model for reversion to the mean of interest rates.
Reminder: Ito Lemma: IfdX = a(X, t)dt + b(X, t)dW
Then
dg(X, t) =(
agx +1
2b2gxx + gt
)
dt + bgxdW .
The Vasicek model isdX = α(r − X)dt + sdW
Look at g(X, t) = eαt(X − r). From Ito:
dg = (α(r − X)eαt + αeαt(X − r))dt + seαtdW = seαtdW .
Integrating, we have
eαt(X(t) − r) − (X(0) − r) = s
∫
t
0eαudW (u)
= s
(
eαtW (t) − α
∫
t
0W (u)eαudu
)
.
To get the last line we have used Ito again, with “g” equal to eαtW (and X = W ).Rearranging gives
X(t) = r + (X(0) − r)e−αt + s
(
W (t) − α
∫
t
0W (u)e−α(t−u)du
)
.
Notes:
1. There is a problem in this model that X can become negative.
2. Everyone not in finance calls the process the “Ohrnstein-Uhlenbeck” process — it hasmany applications outside finance.
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