Coping with Negative Short-Rates

TL;DR

This paper extends the Ho and Lee short-rate model by incorporating reflecting barriers to allow for realistic, time-dependent drifts and positive asymptotic yields, with analytical bond pricing and empirical calibration methods.

Contribution

It introduces a simple, analytically solvable extension of the Ho and Lee model using reflecting barriers, enabling more realistic interest rate modeling with positive yields.

Findings

Bond prices are computed analytically.

The model produces a sensible yield curve with positive asymptotic yield.

Calibration with empirical data is feasible using three parameters.

Abstract

We discuss a simple extension of the Ho and Lee model with generic time-dependent drift in which: 1) we compute bond prices analytically; 2) the yield curve is sensible and the asymptotic yield is positive; and 3) our analytical solution provides a clean and simple way of separating volatility from the drift in the short-rate process. Our extension amounts to introducing one or two reflecting barriers for the underlying Brownian motion (as opposed to the short-rate), which allows to have more realistic time-dependent drift (as opposed to constant drift). In our model the spectrum -- or, roughly, the set of short-rate values contributing to bond and other claim prices -- is discrete and positive. We discuss how to calibrate our model using empirical yield data by fitting three parameters and then read off the time-dependent drift.