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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 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.

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 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 ${\mathbb{E}}^Q[\exp (-{\int }_t^T{r}_{s}ds)\mid r_t=r]$.

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.

A European put option gives its holder the right, without an obligation, to sell one unit of an underlying financial asset at the strike price $K$ only on the expiry date $T$. For one stock share, its terminal financial payoff is the positive partFor strike price $K=100$, terminal stock prices $80$, $100$, and $120$ give financial payoffs $20$, $0$, and $0$, respectively. At $S_T=80$, selling for $100$ rather than the market price $80$ supplies the difference $20$; at $S_T=120$, the holder can let the right expire. Equality at $S_T=100$ gives zero net exercise value. The European call option example plots both financial payoffs on the same axes.

Combining a European put option with the underlying stock share produces the terminal amount $S_T+(K-S_T{)}^{+}=\max (S_T,K)$. Its floor at the strike price is why a European put option can describe protection against a fall in terminal stock value. The protection has an initial cost and lasts to the specified expiry; the terminal floor alone says nothing about the financial return. Put-call parity replicates this same amount with a European call option and a zero-coupon bond.

Using the put-call parity example's price $P_0=10+100e^{-0.05}-100\approx 5.12294245$, the cost financed for one year at interest rate $r=0.05$ grows to $P_0{e}^{0.05}=100-90e^{0.05}\approx 5.38560133$. The terminal net amount is therefore approximately $14.61439867$ when $S_T=80$, and $-5.38560133$ when $S_T=100$ or $120$. These computations use the unrounded price and distinguish the financial payoff from the financed gain. Unlike an American put option, a European put option supplies no right to exercise before $T$.

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 $\alpha (0)=\beta (0)=0$, $\alpha (n+1)=A(1+\alpha (n))$, $\beta (n+1)=\beta (n)+B(1+\alpha (n))$.

A traded claim or instrument carrying a current price and future payments or resale value. In a one-period financial market, its terminal payoff is a random variable and a portfolio combines payoffs linearly through its asset holdings. A stock, a zero-coupon bond and a bank account are basic examples. Dividends require treating the full gain process rather than only resale prices.

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.

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.

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 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 $c$.

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.

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.

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 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.

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.

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 $f(t,t)$.

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.

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.