What is the Hull-White Model?
The Hull-White model prices interest rate derivatives using a single component. The Hull-White model assumes a normal distribution and means reversion for short rates. When short rates are near zero, volatility is minimal; hence, the model has a more significant mean reversion.
The Hull-White model builds on the Vasicek and CIR models.
Knowing the Hull-White Model
An interest rate derivative is a financial instrument whose value mirrors interest rate fluctuations. Institutional investors, banks, enterprises, and individuals utilize interest rate derivatives to hedge against market interest rate fluctuations, modify risk profiles, or speculate on rate movements. These may include interest rate restrictions and floors.
Interest rate-dependent investments like bond options and mortgage-backed securities (MBS) have gained appeal as financial systems have advanced. Each model has its own assumptions for valuing these investments. This made it hard to match volatility characteristics between models and evaluate risk across a portfolio of investments.
Special Considerations
The Hull-White model assumes regularly distributed interest rates, like the Ho-Lee model. Interest rates might be harmful; however, this is unlikely to happen as a model outcome.
The Hull-White model values derivatives as a function of the yield curve, not at a single point. Analysts hedge against economic scenarios since the yield curve anticipates future interest rates, not market rates.
The Brace Gatarek Musiela Model (BGM) utilizes observable rates, such as forward LIBOR rates, unlike the Hull-White and Heath-Jarrow-Morton models, which employ instantaneous short and forward rates.
Who are Hull and White?
John C. Hull and Alan D. White teach finance at the Rotman School of Management, University of Toronto. They created the model in 1990. Professor Hull authored Risk Management, Financial Institutions, Futures, and Options Market Fundamentals. Professor White is an internationally acknowledged financial engineering expert and Associate Editor of the Financial and Quantitative Analysis and Derivatives Journals.
Conclusion
- The Hull-White model prices interest rate derivatives.
- The model assumes extremely short-term rates are typically distributed and return to the mean.
- Instead of a single rate, the Hull-White model estimates derivative prices using the entire yield curve.
