Fixed-income security

A fixed-income security promises cash flows at specified future dates. Its price depends on the term structure of interest rates and the relevant credit and liquidity risks.

A zero-coupon bond makes one payment at maturity and no earlier coupon payments. A unit-face-value bond maturing at $T$ has terminal value $P_T^T=1$.

The continuously compounded yield of a unit-face zero-coupon bond is the constant rate producing its current discount factor over the remaining maturity. It equals the maturity average of the instantaneous forward rate. Differentiation gives $f(t,T)=R(t,T)+(T-t)R_T(t,T)$, and both rates tend to the short rate as $T\downarrow t$. This definition uses continuous compounding; quoted coupon-bond yields require a different cash-flow equation.

Buy one maturity-$(T-1)$ bond and short $1+f$ maturity-$T$ bonds. Reinvest the first bond's unit maturity payoff in $1/P_{T-1}(T)$ maturity-$T$ bonds. This self-financing portfolio pays $r_T-f$ at $T$. The replication uses only the adjacent maturities and does not require completeness of the whole bond market.

In the model $d{r}_t=r_t(r_t-1)(dt+d{W}_t)$ under the pricing measure, with $0\le r_t\le 1$, the discounted affine expression $D_t[A(T-t)+B(T-t)r_t]$ has zero drift when $A^{\prime }=0$ and $B^{\prime }=-A-B$. Terminal conditions $A(0)=1$, $B(0)=0$ yield the displayed unit bond price. The expression is bounded, so the bounded local martingale criterion justifies pricing by conditional expectation.

For the bounded rate diffusion of linear bond pricing in a bounded short-rate diffusion, $D_t{e}^{-(T-t)}{r}_t$ is a bounded martingale with terminal value $D_T{r}_T$. Dividing its conditional expectation by $D_{t}P(t,T)$ through the Bayes formula for conditional expectation gives the displayed forward-measure expectation. It lies between zero and one.

If a discrete-time martingale deflator obeys $Y_t/Y_{t-1}=e^{X_t}$ for an affine process $X$, unit zero-coupon bonds have exponential-affine prices. For one-step coefficients $A,B$, the recursion is $\alpha (0)=\beta (0)=0$, $\alpha (n+1)=A(1+\alpha (n))$, $\beta (n+1)=\beta (n)+B(1+\alpha (n))$.

For an affine autoregressive process $r_T=\beta r_{T-1}+{\xi }_T$, suppose its initial zero-coupon bond prices $q(T)$ are positive and finite. A deterministic shift $h_T$ of the rate changes the bond price to $q(T)\exp (-{\sum }_{s=1}^T{h}_s)$. To fit any positive curve $p(T)$ with $p(0)=1$, put $d_T=\log q(T)-\log p(T)$, $d_0=0$, $h_T=d_T-d_{T-1}$ and $h_0=0$. Adding the deterministic drift ${\alpha }_T=h_T-\beta h_{T-1}$ to the rate recursion realizes precisely this shift, and telescoping gives the desired curve. No stationary autoregression assumption is needed.

An interest rate measures the growth of value across time. In discrete time, a one-period investment at rate $r_t$ grows by the factor $1+r_t$.

A cap limits the floating rate on a notional principal by paying the excess over a strike for successive accrual periods. It is a sum of caplets. For accrual fraction $\delta$ and reset at $T$ with payment at $U$, the unit-notional payoff is $\delta (L(T;T,U)-K{)}^{+}$ at $U$, where $L(T;T,U)=[P(T,U{)}^{-1}-1]/\delta$ and $P$ is a zero-coupon bond price.

One payment period of an interest-rate cap. For $1+\delta K>0$, its value at the reset date is $(1-(1+\delta K)P(T,U){)}^{+}$. Thus the caplet is equivalent before reset to $1+\delta K$ units of a put expiring at $T$ on the maturity-$U$ zero-coupon bond, with strike $(1+\delta K{)}^{-1}$.

For a Gaussian forward-rate field with deterministic volatility, put $F=P(t,U)/P(t,T)$, $K_b=(1+\delta K{)}^{-1}$, and $v^2={\int }_t^T\Vert \Sigma (s,U)-\Sigma (s,T){\Vert }^{2}ds$. Under the T-forward measure, $F$ is lognormal with that integrated variance. With $d_1=\log (F/K_b)/v+v/2$ and $d_2=d_1-v$, the displayed expression is the caplet price. At $v=0$ use the discounted intrinsic bond-put value. Gaussian instantaneous rates do not make the reset floating rate Gaussian; the exponential bond relation is what yields this bond-option formula.

The maturity-indexed curve of interest rates inferred from prices of zero-coupon bonds. Continuously compounded yields $y(t,T)=-\log P(t,T)/(T-t)$ average the instantaneous forward rate over $[t,T]$. Modelling a curve requires both dependence across maturities and consistent evolution through observation time; specifying unrelated one-dimensional rate distributions is insufficient.

An agreement to exchange interest cash flows according to fixed and floating schedules. For unit accrual periods and unit notional, floating-minus-fixed payments are $r_t-s$ at the specified dates. Zero-coupon bonds value the fixed leg and a rolling floating leg supplies the telescoping floating-leg value.

The fixed rate making an interest rate swap have zero initial value. For unit accrual periods, unit notional and payments $r_t-s$, the floating-leg value is $1-P_0(T)$ and the fixed-leg annuity is ${\sum }_{t=1}^T{P}_0(t)$. The formula changes when accrual lengths or payment schedules differ.

A model evolving the entire instantaneous forward rate curve. In the displayed one-factor risk-neutral measure dynamics the drift restriction makes every suitably integrable discounted zero-coupon bond price a martingale. The multi-factor form replaces the product of volatilities by their dot product.

For a maturity-differentiable Heath-Jarrow-Morton model forward field with the integrability needed for stochastic differentiation, the short rate $r_t=f(t,t)$ has the displayed dynamics. Indeed changing observation time uses the forward-rate stochastic differential equation, while changing maturity adds ${\partial }_{T}f(t,t)dt$. Under a risk-neutral measure, $\alpha (t,T)=\sigma (t,T){\int }_t^T\sigma (t,u)du$, so $\alpha (t,t)=0$. The remaining drift depends on the diagonal slope of the whole forward curve, which need not be determined by $r_t$; a Markov process for the short rate is an additional modelling restriction. Without sufficient maturity regularity, the diagonal need not admit this classical Itô process formula.

For the Heath-Jarrow-Morton model with $\sigma (t,T)=T-t$, the risk-neutral drift is $\alpha (t,T)=(T-t{)}^3/2$. Its short rate is $r_t=f(0,t)+t^4/8+{\int }_0^t{W}_{s}ds$. The centered integrated Brownian component is not Markov: its past reveals its derivative $W_t$, which affects the conditional mean of future increments, whereas its current integral does not determine $W_t$. Indeed the conditional variance of $W_t$ given the current integral is $t/4$. A one-dimensional driving noise therefore does not force a one-dimensional Markov state.

With deterministic Hilbert-space-valued volatility, a deterministic initial curve and the Heath-Jarrow-Morton model drift restriction, the instantaneous forward rate is a Gaussian random field indexed by observation time and maturity. Put $\Sigma (t,T)={\int }_t^T\sigma (t,u)du$. Absence of arbitrage requires $\alpha (t,T)=⟨\sigma (t,T),\Sigma (t,T)⟩$. Indeed, Itô formula gives bond drift $r_t-{\int }_t^T\alpha (t,u)du+\Vert \Sigma (t,T){\Vert }^2/2$; equating it to the short rate and differentiating in maturity yields this restriction. The field covariance isFinite-dimensional volatility spaces give finite-factor models; an infinite-dimensional space permits much richer maturity correlations. Gaussian rates can be negative. Deterministic volatility gives explicit zero-coupon bond and bond-option formulas.

For a centered Gaussian forward-rate field with covariance $\mathrm{Cov}(X(s,u),X(r,w))=c(s\wedge r,u,w)$, integrate the short-rate past and the current forward curve together using the displayed mean-square integral. Its variance isFor fixed $T$, its increments are independent of the full earlier forward-rate filtration: their covariance with $X(z,w)$ at $z\le r\le s$ is the integral of $c(s\wedge u\wedge z,u,w)-c(r\wedge u\wedge z,u,w)=0$. Use the uncorrelated jointly Gaussian variables are independent principle first for finite collections and then for their generated sigma-algebra. With $c(0,u,w)=0$, this centered process starts at zero.

Suppose the instantaneous forward rate field has mean ${\mu }_{s,T}$ and covariance $c(s\wedge r,T,U)$, with deterministic initial curve and suitable integrability and maturity regularity. Its discounted zero-coupon bond prices are martingales exactly when the displayed mean identity holds. PutThe discounted bond price is $\exp [-A(s,T)-Y(s,T)]$, where $Y$ is the integrated Gaussian forward-rate process. Its conditional Gaussian exponential expectation gives the equivalent identity $A(s,T)-A(0,T)=v(s,T)/2$. Differentiating this in maturity gives the displayed restriction. Conversely, integrating that restriction on the diagonal and along the current curve recovers the half-variance identity, by symmetry of the covariance over the maturity square. The Gaussian exponential martingale with deterministic variance then verifies the full conditional martingale property. This formulation does not require a time derivative of $c$.

For time-to-maturity coordinates $g_t(x)=f(t,t+x)$ and time-homogeneous deterministic Heath-Jarrow-Morton model volatility, $A(x)=⟨\sigma (x),{\int }_0^x\sigma (u)du⟩$. The displayed evolution contains the maturity shift. Its mild solution is $g_t(x)=g_0(x+t)+{\int }_0^{t}A(x+s)ds+{\int }_0^t⟨\sigma (x+t-s),d{W}_s⟩$. The whole curve is a time-homogeneous Markov process under suitable function-space well-posedness conditions; the current short rate alone need not be a sufficient state.

If the displayed covariance is finite and the mean obeys $m^{\prime }(x)+A(x)=0$, initialize the Musiela forward-curve equation with the corresponding Gaussian random field, independently of future noise. The resulting curve is stationary in time. Indeed shifting the initial covariance contributes the integral over $[t,\infty )$ and fresh noise contributes the integral over $[0,t]$, so their sum is $K$. A deterministic initial curve generally is not stationary, and nondecaying volatility may make $K(x,x)$ infinite. Exponentially decaying finite-factor volatilities give stationary Ornstein-Uhlenbeck processes.

For a maturity-$T$ call on a unit maturity-$U$ zero-coupon bond, where $t<T<U$, deterministic forward-rate volatilities make the bond-price ratio lognormal under the T-forward measure. Its integrated variance is $V={\int }_t^T\Vert \Sigma (s,U)-\Sigma (s,T){\Vert }^{2}ds$. For $V>0$, put $d_1=[\log (P(t,U)/(KP(t,T)))+V/2]/\sqrt{V}$ and $d_2=d_1-\sqrt{V}$. Integrating the lognormal distribution above the strike gives the displayed price. At $V=0$, the price is $(P(t,U)-KP(t,T){)}^{+}$. The forward measure is essential: the raw bond price has a stochastic discount rate under the money-market measure.

Suppose $d{r}_t=a(r_t)dt+b(r_t)d{W}_t$ under a risk-neutral measure and $f_t(T)=F(T-t,r_t)$. By Itô formula, the forward-rate volatility is ${\sigma }_t(T)=b(r_t)F_r(T-t,r_t)$. The Heath-Jarrow-Morton model drift restriction is equivalent toTo verify it directly for bonds, put $G(\theta ,r)={\int }_0^{\theta }F(s,r)ds$. Integration gives $F-r=a{G}_r+\frac{1}{2}{b}^2{G}_{rr}-\frac{1}{2}{b}^2{G}_r^2$. The zero-coupon bond price $P(t,T)=e^{-G(T-t,r_t)}$ therefore satisfiesIts bank-account-discounted price is a positive local martingale. A common equivalent local martingale measure excludes admissible arbitrage for any finite collection of these traded maturities.

In the one-factor Heath-Jarrow-Morton model, put $b_t^T={\int }_t^T\sigma (t,u)du$. The Itô formula gives $dP/P=r_{t}dt-b_t^{T}d{W}_t$. Thus multiplying by the discount factor yields the displayed stochastic exponential. Bounded forward volatility on a finite maturity horizon implies the Novikov condition, so the discounted bond is a true martingale.

A multiplicative factor converting a value into units of a chosen initial account. With the continuous-time bank account $B$, $D_t=1/B_t$; discounted traded asset prices are martingales under the corresponding equivalent martingale measure.

The continuously compounded rate inferred for an infinitesimal investment interval at future maturity $T$, as seen at time $t$. For a unit-face-value zero-coupon bond, $P(t,T)=\exp (-{\int }_t^{T}f(t,u)du)$ and the short rate is $f(t,t)$.

The instantaneous continuously compounded interest rate. The continuous-time bank account grows at this rate; it equals the instantaneous forward rate at current maturity.

The Gaussian Hull-White model has pricing dynamics $d{r}_t=(\beta (t)-a{r}_t)dt+\eta d{W}_t^Q$. Its deterministic drift function can fit the initial yield curve exactly, while its Ornstein-Uhlenbeck process part controls stochastic variation. Like the Vasicek model, it permits negative rates.

Let $f_0(t)$ be the initial instantaneous forward rate curve and choose $r_0=f_0(0)$. In the Hull-White model, take $\beta (t)=f_0^{\prime }(t)+a{f}_0(t)+{\eta }^2(1-e^{-2at})/(2a)$. To verify the fit, write $r_t=x_t+\varphi (t)$ with $d{x}_t=-a{x}_{t}dt+\eta d{W}_t^Q$, $x_0=0$, and $\varphi (t)=f_0(t)+{\eta }^2(1-e^{-at}{)}^2/(2a^2)$. The Gaussian exponential formula gives $-{\partial }_T\log P(0,T)=\varphi (T)-{\eta }^2(1-e^{-aT}{)}^2/(2a^2)=f_0(T)$.

A one-factor short-rate model specifies $d{r}_t=\mu (t,r_t)dt+\eta (t,r_t)d{W}_t$ with deterministic coefficient functions. All zero-coupon bond prices are functions of time, maturity and this single scalar state. The physical drift and pricing drift differ by $\eta \lambda$, where $\lambda$ is the market price of risk.

For smooth derivative prices depending on a Markov short rate, Itô formula gives physical drift $m=V_t+b{V}_r+{\sigma }^2{V}_{rr}/2$ and exposure $s=\sigma V_r$. The common short-rate market price of risk gives $m-rV=\theta s$, yielding this equation. Under the risk-neutral measure, the rate drift is $b-\sigma \theta$ and the bank-discounted price is a martingale under suitable integrability. A unit zero-coupon bond has terminal value one and price ${\mathbb{E}}^Q[\exp (-{\int }_t^T{r}_{s}ds)\mid r_t=r]$.

If all traded zero-coupon bonds depend on one scalar rate driven by one Brownian motion, their diffusion exposures form one vector $v_i=\eta P_{i,r}$. Their instantaneous covariance matrix is $v{v}^T$, of rank at most one. Nondegenerate maturity changes are therefore instantaneously perfectly correlated, with correlation $+1$ or $-1$, though finite-horizon bond-return correlations need not be one.

For pricing drift ${\mu }_Q$, a unit zero-coupon bond price $P(t,r;T)$ satisfies $P_t+{\mu }_Q{P}_r+{\eta }^2{P}_{rr}/2-rP=0$, with $P(T,r;T)=1$. Itô formula makes its bank-account-discounted value a local martingale; suitable integrability gives $P(t,r;T)={\mathbb{E}}^Q[\exp (-{\int }_t^T{r}_{s}ds)\mid r_t=r]$. The rate kills the diffusion semigroup, as in the Feynman-Kac formula.

In a one-factor short-rate model, a derivative $V(t,r)$ can be hedged locally by a nondegenerate traded zero-coupon bond $P(t,r;T_1)$. Match Brownian exposures by holding $V_r/P_r$ bonds and putting the remaining value into the bank account. Substitution into the two pricing equations proves the gain identity. This requires $\eta P_r\ne 0$; completeness at a degenerate boundary cannot be inferred from the dimension count alone.

When ${\mu }_Q=a(b-r)$ and $\eta (r{)}^2={\eta }_0^2+{\eta }_1^{2}r$, substituting $P=A(\tau )e^{-B(\tau )r}$ gives $B^{\prime }=1-aB-{\eta }_1^2{B}^2/2$ and $(\log A{)}^{\prime }=-abB+{\eta }_0^2{B}^2/2$, with $B(0)=0$, $A(0)=1$. The Vasicek model uses ${\eta }_1=0$, and the CIR model uses ${\eta }_0=0$.

A Gaussian short rate model with Ornstein-Uhlenbeck process dynamics under the chosen pricing measure. For $a>0$, its unit zero-coupon bond value is $P(t,T)=A(\tau )e^{-B(\tau )r_t}$, where $\tau =T-t$, $B(\tau )=(1-e^{-a\tau })/a$ andSolve the linear stochastic differential equation, integrate over future time, and use the exponential moment of the resulting Gaussian integral to obtain this price. Its Gaussian law permits negative short rates.

Under a risk-neutral measure $Q$, let the short rate be $r_t=g(t)+\sigma W_t^Q$, with deterministic locally integrable $g$ and constant $\sigma >0$. For a zero-coupon bond paying one at $T$, the risk-neutral pricing value isIndeed, conditional on ${\mathcal{F}}_t$, the random part of the integrated future short rate is $\sigma {\int }_t^T(T-u)d{W}_u^Q$, which is Gaussian with mean zero and variance ${\sigma }^2(T-t{)}^3/3$. Its exponential moment gives the formula. At points where $g$ is continuous, the instantaneous forward rate isFor merely locally integrable $g$, the same identity holds almost everywhere. The model allows negative short rates and gives explicit bond prices and forward curves.

To match a prescribed initial instantaneous forward rate curve $F_0(T)$ in the Gaussian short-rate model with a deterministic shift, chooseSince $W_0^Q=0$, its model forward rate is then $f_0(T)=g(T)-{\sigma }^2{T}^2/2=F_0(T)$. Moreover,so the initial zero-coupon bond curve matches as well. A continuous initial forward curve gives pointwise calibration; a locally integrable curve gives the corresponding almost-everywhere interpretation of the instantaneous forward rate.

For $d{r}_t=a_{0}dt+b_{0}d{W}_t$ under a risk-neutral measure, the instantaneous forward rate and zero-coupon bond prices areIndeed, conditional on current information, ${\int }_t^T{r}_{s}ds$ is Gaussian with mean $(T-t)r_t+a_0(T-t{)}^2/2$ and variance $b_0^2(T-t{)}^3/3$. Its negative exponential expectation gives the bond formula, and differentiating its logarithm gives the instantaneous forward rate. Equivalently the affine forward-rate equation has $A^{\prime }=0$, $A(0)=1$, and $B^{\prime }=a_0-b_0^2\theta$, $B(0)=0$. This is the constant-drift instance of the Ho-Lee Gaussian short rate model; the model permits negative short rates.

A nonnegative mean-reverting short-rate diffusion with positive parameters. Its mean-reversion level is $a/b$ and its diffusion size is proportional to $\sqrt{r}$. The Feller positivity condition for the CIR model controls whether zero is reachable. Its stationary law is a gamma distribution and its zero-coupon bond prices are exponential-affine.

For $d{C}_t=a(b-C_t)dt+\sigma \sqrt{C_t}d{W}_t$, the Itô formula applied to $Z=\sqrt{C}$ gives the displayed dynamics before hitting zero. In particular $2ab={\sigma }^2$ does not eliminate the reciprocal drift. The cancellation condition is $4ab={\sigma }^2$. Under that condition $C$ can be represented as the square of a signed Ornstein-Uhlenbeck process with drift $-aY/2$ and volatility $\sigma /2$; its principal square root is the reflected process $|Y|$, not an unrestricted signed OU process. The mean of $C$ is $b+(C_0-b)e^{-at}$ for all admissible positive parameters.

For the CIR model under its money-market risk-neutral measure, the Feynman-Kac formula gives $B^{\prime }=1-bB-{\sigma }^2{B}^2/2$ and $A^{\prime }/A=-aB$, with $B(0)=0$, $A(0)=1$. Solving this Riccati equation gives explicit exponential-affine zero-coupon bond prices. The positive root parameter is $\sqrt{b^2+2{\sigma }^2}$; the squared diffusion coefficient, not the volatility itself, enters this expression.

For a CIR model started at a positive rate, this condition makes the zero boundary inaccessible. Below the threshold, zero can be reached, but the usual nonnegative solution does not cross into negative rates. Thus nonnegativity and strict positivity are different properties.

The time-$t$ one-period spot interest rate is the rate available for investment from $t$ to $t+1$. For a unit-face-value zero-coupon bond,

In a discrete-time market, the bank account reinvests at each successive spot interest rate:

Reinvest each maturity payment in the next unit-principal zero-coupon bond. Positive bond prices make the resulting self-financing portfolio strictly positive, so it can be used as a numéraire. Its one-step growth is the reciprocal of the current one-period bond price.

The value of an account that continuously reinvests at the short rate $r$, with $B_0=1$. Its reciprocal is the discount factor $D_t=B_t^{-1}$.