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Models, Valuation, Projections, and Fitting

Introduction

Conceptually, we have an iterative process:

  1. We use models to value contracts
  2. We use observed (or assumed) prices to calibrate models

Thus the discussion of model calibration and valuation of contracts is inextricably linked together.

Yield (Interest Rate) models

Rates

We should first discuss Rates, which are reexported from FinanceCore.jl

Rates are types that wrap scalar values to provide information about how to determine discount and accumulation factors. These allow for explicit handling of rate compounding conventions which, if not explicit, is often a source of errors in practice.

There are two Frequency types:

  • Yields.Periodic(m) for rates that compound m times per period (e.g. m times per year if working with annual rates).
  • Yields.Continuous() for continuously compounding rates.

Examples

Continuous(0.05)       # 5% continuously compounded
Periodic(0.05,2)       # 5% compounded twice per period

These are both subtypes of the parent Rate type and are instantiated as:

Rate(0.05,Continuous())       # 5% continuously compounded
Rate(0.05,Periodic(2))        # 5% compounded twice per period

Broadcast over a vector to create Rates with the given compounding:

Periodic.([0.02,0.03,0.04],2) 
Continuous.([0.02,0.03,0.04])

Rates can also be constructed by specifying the CompoundingFrequency and then passing a scalar rate:

Periodic(1)(0.05)
Continuous()(0.05)

Conversion

Convert rates between different types with convert. E.g.:

r = Rate(0.01,Periodic(12))             # rate that compounds 12 times per rate period (ie monthly)

convert(Yields.Periodic(1),r)                  # convert monthly rate to annual effective
convert(Yields.Continuous(),r)          # convert monthly rate to continuous

To get the scalar value out of the Rate, use FinanceModels.rate(r):

julia> r = Rate(0.01,Periodic(12));   
julia> rate(r)
0.01

Available Models - Yields

Arithmetic

Adding, subtracting, multiplying, dividing, and comparing rates is supported.

Yield models can also be composed. Here is an example of fitting rates and spread separately and then adding the two models together:

julia> q_rate = ZCBYield([0.01,0.02,0.03]);

julia> q_spread = ZCBYield([0.01,0.01,0.01]);

julia> m_rate = fit(Spline.Linear(),q_rate,Fit.Bootstrap());⠀           

julia> m_spread = fit(Spline.Linear(),q_spread,Fit.Bootstrap());

julia> forward(m_spread + m_rate,0,1)
Rate{Float64, Continuous}(0.01980262729617973, Continuous())

julia> forward(m_spread + m_rate,0,1) |> Periodic(1)
Rate{Float64, Periodic}(0.020000000000000018, Periodic(1))

julia> discount(m_spread + m_rate,0,3)
0.8889963586709149

julia> discount(0.04,3)
0.8889963586709148
Caution with Spreads

It is fairly common to see spreads and rates provided separately where both are quoted in par convention. For example, US Treasury par rates with the associated par risk spreads. Because par rates are dependent on the amount and path of rates preceeding the given tenor, it is not valid to construct a "spread curve" with par rates and then use it in composition with a "rate curve".

That is, while the zero rates and spreads in the preceeding example allow for additive or subtractive composition, it is not the case for par rates and spreads. Note the different discount factors produced:

q_rate = ParYield([0.01,0.02,0.03]);
q_spread = ParYield([0.01,0.01,0.01]);
q_yield = ParYield([0.02,0.03,0.04]);

m_rate = fit(Spline.Linear(),q_rate,Fit.Bootstrap());         
m_spread = fit(Spline.Linear(),q_spread,Fit.Bootstrap());
m_yield = fit(Spline.Linear(),q_yield,Fit.Bootstrap());

# The curves are different!
discount(m_spread + m_rate,3)
# 0.8889963586709149

discount(m_yield,3)
# 0.8864366955434709

Creating New Yield Models

See the FinanceModels.jl Guide for an example of creating a model from scratch. Some additional aspects to note:

Equity and Volatility Models

Available Models - Option Valuation

Available Models - Volatility

Creating new Volatility Models

A volatility model must extend volatility(vol::Volatility.MyNewModel, strike_ratio, time_to_maturity).