- Cox-Ingersoll-Ross model
The Cox-Ingersoll-Ross model in finance is a
mathematical modeldescribing the evolution of interest rates. It is a type of "one factor model" ( Short rate model) as describes interest rate movements as driven by only one source of market risk. The model can be used in the valuation of interest rate derivatives. It was introduced in 1985by John C. Cox, Jonathan E. Ingersolland Stephen A. Ross as an extension of the Vasicek model.
The model specifies that the
instantaneous interest ratefollows the stochastic differential equation, also named the CIR process:
where "Wt" is a
Wiener processmodelling the random market risk factor.
The drift factor, , is exactly the same as in the Vasicek model. It ensures
mean reversionof the interest rate towards the long run value "b", with speed of adjustment governed by the strictly positive parameter "a".
standard deviationfactor, , corrects the main drawback of Vasicek's model, ensuring that the interest rate cannot become negative. Thus, at low values of the interest rate, the standard deviation becomes close to zero, cancelling the effect of the random shock on the interest rate. Consequently, when the interest rate gets close to zero, its evolution becomes dominated by the drift factor, which pushes the rate upwards (towards equilibrium).
An arbitrage-free bond may be priced using this interest rate process. The bond price is exponential affine in the interest rate:
*cite book | author=Hull, John C. | title=Options, Futures and Other Derivatives| year=2003 | publisher = Upper Saddle River, NJ:
Prentice Hall| id = ISBN 0-13-009056-5
*cite journal | author=Cox, J.C., J.E. Ingersoll and S.A. Ross | title=A Theory of the Term Structure of Interest Rates | journal=
Econometrica| year=1985 | volume=53 | pages=385–407 | doi=10.2307/1911242
Wikimedia Foundation. 2010.