Bond Formulae for the Black-Karasinski Short Rate Model

Colin Turfus
June 30, 2019

We follow the notation of Turfus (2018) in denoting, for a forward rate r(t), mean reversion rate αr (t) and instan-
taneous short rate volatility σr (t):
m Rv
j
X
t
r(u)du
Dm (t, v) = D(t, v) , m ≥ 0, (1)
j=0
j!
Rv
φr (t, v) = e− t αr (u)du , (2)
Z v
Σrr (t, v) = φ2r (u, v)σr2 (u)du. (3)
t
r̃1 (t) = r(t), (4)
Z t  
r̃2 (t) = r̃1 (t) r̃1 (t1 ) eφr (t1 ,t)Σrr (0,t1 ) − 1 dt1 , (5)
0
Z t  
r̃3 (t) = (r̃1 (t)r̃2 (t1 ) + r̃2 (t)r̃1 (t1 )) eφr (t1 ,t)Σrr (0,t1 ) − 1 dt1
0
Z t Z t1  
+ r̃1 (t) r̃1 (t1 ) r̃1 (t2 ) eφr (t1 ,t)Σrr (0,t1 )+φr (t2 ,t1 )Σrr (0,t2 ) − 1 dt2 dt1 , (6)
0 0
2
Ri (x, t, t1 ) = r̃i (t1 )eφr (t,t1 )x−φr (t,t1 )Σrr (0,t) , i > 0,
(7)
j
Rki (x, t, ti )e1i>1 φr (ti−1 ,ti )Σrr (t,ti−1 ) ,
Y
R[k1 ,k2 ,...,kj ] (x, t, t1 , t2 , . . . , tj ) = (8)
i=1

so that, in particular,
R[1,1] (x, t, t1 , t2 ) = R1 (x, t, t1 )R1 (x, t, t2 )eφr (t1 ,t2 )Σrr (t,t1 ) . (9)
Rv
Note that, denoting ∆(t, v) = t r(u)du, we can also write for convenient computational purpose:

D0 (t, v) = e−∆(t,v) (10)

−∆(t,v)
D1 (t, v) = e (1 + ∆(t, v)) (11)
−∆(t,v) 1 2
D2 (t, v) = e (1 + ∆(t, v) + 2 ∆ (t, v)) (12)
D3 (t, v) = e−∆(t,v) (1 + ∆(t, v) + 1 2 1 3
2 ∆ (t, v) + 3! ∆ (t, v)) (13)

If αr (·) and σr (·) are constant we can also simplify

σr2  
Σrr (t, v) ≡ 1 − e−2αr (v−t) ,
2αr
σ2
φr (t, t1 )Σrr (0, t) ≡ r e−αr t1 sinh αr t.
αr

1
 The T -maturity zero coupon bond price under the Black-Karasinski model is then given to first order by
Z T
f1T (x, t) = D1 (t, T ) − D0 (t, T ) R1 (x, t, t2 )dt1 , (14)
t

to second order by
Z T Z T
f2T (x, t) = D2 (t, T ) − D1 (t, T ) R[1] (x, t, t1 )dt1 − D0 (t, T ) R[2] (x, t, t1 )dt1
t t
Z T Z t2
+ D0 (t, T ) R[1,1] (x, t, t1 , t2 )dt1 dt2
t t
Z T Z T
= D2 (t, T ) − D1 (t, T ) R1 (x, t, t1 )dt1 − D0 (t, T ) R2 (x, t, t1 )dt1
t t
Z T Z t2
+ D0 (t, T ) R1 (x, t, t2 ) R1 (x, t, t1 )eφr (t1 ,t2 )Σrr (t,t1 ) dt1 dt2 (15)
t t

and to third order by

Z T Z T
f3T (x, t) = D3 (t, T ) − D2 (t, T ) R[1] (x, t, t1 )dt1 − D1 (t, T ) R[2] (x, t, t1 )dt1
t t
Z T Z t2 Z T
+ D1 (t, T ) R[1,1] (x, t, t1 , t2 )dt1 dt2 − D0 (t, T ) R[3] (x, t, t1 )dt1
t t t
Z T Z t2
+ D0 (t, T ) (R[1,2] (x, t, t1 , t2 ) + R[2,1] (x, t, t1 , t2 ))dt1 dt2
t t
Z T Z t3 Z t2
− D0 (t, T ) R[1,1,1] (x, t, t1 , t2 , t3 )dt1 dt2 dt3 . (16)
t t t

References
Turfus, C., Exact Arrow-Debreu Pricing for the Black-Karasinski Short Rate Model, Working Paper, 2018, https:
//ssrn.com/abstract=3253839.