JOURNAL OF APPLIED MATHEMATICS AND DECISION SCIENCES, 8(1), 1–14

Copyright
c 2004, Lawrence Erlbaum Associates, Inc.

Three Ways to Solve for Bond Prices in the

Vasicek Model
ROGEMAR S. MAMON † roge@stat.ubc.ca
Department of Statistics, University of British Columbia
Vancouver, BC, Canada V6T 1Z2

Abstract. Three approaches in obtaining the closed-form solution of the Vasicek bond
pricing problem are discussed in this exposition. A derivation based solely on the distri-
bution of the short rate process is reviewed. Solving the bond price partial differential
equation (PDE) is another method. In this paper, this PDE is derived via a martingale
approach and the bond price is determined by integrating ordinary differential equations.
The bond pricing problem is further considered within the Heath-Jarrow-Morton (HJM)
framework in which the analytic solution follows directly from the short rate dynamics
under the forward measure.

Keywords: Bond pricing, Vasicek model, Martingales, HJM methodology, Forward

measure.

1. Introduction

Vasicek’s pioneering work (1977) is the first account of a bond pricing model
that incorporates stochastic interest rate. The short rate dynamics is mod-
eled as a diffusion process with constant parameters. When the bond price
is based on this assumption, it has the feature that on a given date, the
ratio of expected excess return per unit of volatility (the market price of
risk) is the same, regardless of bond’s maturity. Vasicek’s model is a spe-
cial version of Ornstein-Uhlenbeck (O-U) process, with constant volatility.
This implies that the short rate is both Gaussian and Markovian. The
model also exhibits mean-reversion and is therefore able to capture mon-
etary authority’s behavior of setting target rates. Furthermore, historical
experience of interest rates justifies the O-U specification.
Given the pedagogical value of the Vasicek model in stochastic term struc-
ture modeling, the purpose of this paper is to present alternative derivation
of the bond price solution. From the bond price the entire yield curve can
be constructed at any given time. Thus, in turn, the term structure dy-
namics is characterized by the evolution of the short rate.
† Requests for reprints should be sent to Rogemar S. Mamon, Department of Statistics,
University of British Columbia, Vancouver, BC, Canada V6T 1Z2.
2 R. S. MAMON

Vasicek model’s tractability property in bond pricing and the model’s

interesting stochastic characteristics make this classical model quite pop-
ular. In this paper a review of short rate’s stochastic properties relevant
to the derivation of the closed-form solution of the bond price within the
Vasicek framework is presented. These properties become the basis for the
first method examined in section 2. Under this technique, the bond price is
derived from the implications of the interest rate’s probability distribution.
The development of the theory under this set-up follows from the outline
of Lamberton and Lapeyre (1995).
The orginal derivation of the explicit formula for the bond price was
based on solving the PDE that must be satisfied by the bond price. This is
done by constructing a locally riskless portfolio and using the no-arbitrage
arguments. Duffie and Kan (1996) provide a further characterization of
this PDE. They prove that, if some Ricatti equations have solutions to the
required maturity, the bond price has an exponential affine form. Vasicek’s
model belongs to this exponential affine class because the specification of
its drift and volatility gives rise to a solvable set of equations in accordance
with the Duffie-Kan descriptions. The second approach discussed in sec-
tion 3 relies on the solution of the bond price PDE. However, unlike the
traditional approach, this paper presents a martingale-oriented derivation
of this PDE. This is motivated by the equivalence of the no-arbitrage pric-
ing technique and the risk-neutral valuation which is a martingale-based
method. Recently, Elliott and Van der Hoek (2001) offer a new method
of solving the problem studied by Duffie and Kan. In their paper, it is
shown that, when the short rate process is given by Gaussian dynamics
or square root processes, the bond price is an exponential affine function.
Their technique determines the bond price by integrating linear ODE and
Ricatti equations are not needed. A similar idea is applied here to provide
a solution to the bond pricing problem in the Vasicek model.
Section 4 presents a third alternative that considers the Heath-Jarrow-
Morton (HJM) pricing paradigm. The equivalence between the forward
rate and the conditional expectation of the short rate under the forward
measure is discussed. Elaborating on the work of Geman, El Karoui and
Rochet (1995) using the bond price as a numéraire, the short rate’s dy-
namics is obtained under the forward measure. Consequently, the Vasicek
forward rate dynamics is explicitly determined and therefore the analytic
bond price follows immediately from the HJM bond pricing formula.
THREE WAYS TO SOLVE FOR BOND PRICES 3

2. Bond Price Implied by the Short Rate Distribution

In modeling the uncertainty of interest rates, assume that there is an un-

derlying probability space (Ω, F, P ) equipped with a standard filtration
{Ft }. Under the risk-neutral measure P, the short rate dynamics is given
by
drt = a(b − rt )dt + σdWt (1)
where a, b and σ are all positive constants.
It can be verified using Itô’s formula that
 Z t Z t 
−at au au
rt = e r0 + abe du + σ e dWu
0 0

is a solution to the stochastic differential equation (SDE) in (1). Note

further that
 Z t 
−at at au
rt = e r0 + b(e − 1) + σe dWu
0
Z t
= µt + σ ea(u−t) dWu ,
0

where µt is a deterministic function. Clearly, E[rt ] = µt .

Observe further that rt is a Gaussian random variable. This follows from
Pn−1 a(ui −t)
the definition of the stochastic integral term, which is lim i=0 e (Wui+1 −
|π|→0
Wui ) and the increment (Wui+1 − Wui ) ∼ N (0, ui+1 − ui ). In general, if δ
Rt
is deterministic (i.e., a function only of t), 0 δ(u)dWu is Gaussian.
While the expectation follows immediately from the solution for rt given
above, E[rt ] can be determined without necessarily solving explicitly the
SDE. Consider the integral form of (1). That is,
Z t
rt = r0 + (a(b − ru )du + σdWu ).
0

Hence, Z t
µt := E[rt ] = r0 + a(b − E[ru ])du. (2)
0
From (2),
d
µt = a(b − µt ),
dt
which is a linear ordinary differential equation (ODE). Consequently, using
the integrating factor eat
E[rt ] = e−at [r0 + b(eat − 1)] = µt . (3)
4 R. S. MAMON

In this model, b is some kind of level r is trying to attain. We call this

the mean-reverting level. Similarly, define
 Z t 
σt2 : = V ar[rt ] = E σe−at eau dWu )2
0
Z t 
= σ 2 e−2at E e2au du by Itô’s isometry
0
1 − e−2at
 
= σ2 . (4)
2a
Therefore, rt ∼ N (µt , σt2 ) with mean and variance given in (3) and (4),
respectively.
Since normal random variables can become negative with positive prob-
ability, this is considered to be the weakness of the Vasicek model. Never-
theless, the simplicity and tractability of the model validate its discussion.
Using the risk-neutral valuation framework, the price of a zero-coupon
bond with maturity T at time t is
" Z T ! #

B(t, T ) = E exp − ru du  Ft .

t 

Write
X(u) = ru − b. (5)
Here, X(u) is the solution of the Ornstein-Uhlenbeck equation

dX(t) = −aX(t) + σdWt (6)

with X(0) = r0 − b. Applying Itô’s lemma, the X(u) process is given by

 Z u 
X(u) = e−au X(0) + σeas dWs . (7)
0

Clearly, X(u) is a Gaussian process with continuous sample paths. If

Rt
X(u) is Gaussian then 0 X(u)du is also Gaussian. Using (7), we obtain

E[X(u)] = X(0)e−au .

Thus, Z t 
X(0)
E X(u)du = (1 − e−at ). (8)
0 a
THREE WAYS TO SOLVE FOR BOND PRICES 5

Similarly,
Z t Z u 
Cov[X(t), X(u)] = σ 2 e−a(u+t) E eas dWs eas dWs
0 0
u∧t
σ 2 −a(u+t) 2a(u∧t)
Z
= σ 2 e−a(u+t) e2as ds = e (e − 1).
0 2a
Consequently,
Z t  Z t Z t 
V ar X(u)du = Cov X(u)du, X(s)ds
0 0 0
Z t Z t  Z t Z t 
=E X(u)du − E X(u)du X(s)ds − E X(s)ds
0 0 0 0
Z tZ t
= E[(X(u) − E[X(u)])(X(s) − E[X(s)])]duds
0 0
Z tZ t Z tZ t 2
σ −a(u+s) 2a(u∧s)
= Cov[X(u), X(s)]duds = e (e − 1)duds
0 0 0 0 2a
σ2
= 3 (2at − 3 + 4e−at − e−2at ). (9)
2a
From (5), we have
 Z t   Z t 
E − ru du = E − (X(u) + b)du .
0 0

Therefore, together with equation (8)

" Z #
T
rt − b
E − ru du = − (1 − e−a(T −t) ) − b(T − t). (10)
t a

Furthermore,
" Z # "Z #
T T
V ar − ru du = V ar X(u)du
t t

σ2
= (2a(T − t) − 3 + 4e−a(T −t) − e−2a(T −t)(11)
)
2a3
by the result from (9).
From the Itô integral representation of rt , we also note that the defining
process for the short rate is also Markov. For proof, see Karatzas and
Shreve, p. 355.
6 R. S. MAMON

Thus,
" ! # " ! #
Z T  Z T 
B(t, T ) = E exp − ru du  Ft = E exp − ru du  rt .
 
t  t 

We write
" ! # " !#
Z T  Z T
B(t, T, rt ) := E exp − ru du  rt = E exp − ru (rt )du .

t  t

That is, ru is a function of rt .

Combining (10) and (11), the bond price is given by
" Z # " Z #!
T T
1
B(t, T, rt ) = exp E − ru (rt )du + V ar − ru (rt )du
t 2 t

rt − b
= exp − (1 − e−a(T −t) ) − b(T − t)
a
σ2

+ 3 (2a(T − t) − 3 + 4e−a(T −t) − e−2a(T −t) ) (12)
4a
1 − e−a(T −t) 1 − e−a(T −t)
    
= exp − rt + b − (T − t)
a a
σ 2 1 − e−a(T −t) σ2 σ 2 1 − 2e−a(T −t) + e−2a(T −t)
   
− 2 + 2 (T − t) −
2a a 2a 4a a2
2

σ
= exp −A(t, T )rt + bA(t, T ) − b(T − t) − 2 A(t, T )
2a
σ2 σ2

+ 2 (T − t) − A(t, T )2 = exp(−A(t, T )rt + D(t, T )), (13)
2a 4a
where
1 − e−a(T −t)
A(t, T ) = and (14)
a 
σ2 σ 2 A(t, T )2

D(t, T ) = b − 2 [A(t, T ) − (T − t)] − . (15)
2a 4a

Since for all t, the yield − log B(t,T,r

T −t
t)
obtained from (13) is affine in rt ,
equation (13) is called an affine term structure model or an exponential
affine bond price.
THREE WAYS TO SOLVE FOR BOND PRICES 7

3. Solution via Bond Price PDE

Under this approach, the derivation is based on the fact that the ru process
is Markov. In other words, to determine how ru evolves from t we need
know only the value of rt , u ≥ t. Thus,
" Z T ! #

B(t, T, rt ) = E exp − ru (rt )du  rt

t 

and  Z u 
ru = e−a(u−t) rt + b(ea(u−t) − 1) + σ ea(v−t) dWv .
t

With rt as a parameter,

∂ru (rt )
= e−a(u−t) .
∂rt
So Z T Z T
∂ru (rt ) 1
du = e−a(u−t) du = (1 − e−a(T −t) ),
t ∂rt t a
which is deterministic.
Also,
" Z T ! Z T !#
∂B(t, T, rt ) ∂ru (rt )
= E − du exp − ru (rt )du
∂rt t ∂rt t
" Z T !#
1 −a(T −t)
= − (1 − e )E exp − ru (rt )du
a t

= −A(t, T )B(t, T, rt ),
where A(t, T ) is given as in (14).
∂B
Thus, ∂r t
= −AB. So,

B(t, T, rt ) = C(t, T )exp(−A(t, T )rt ),

for some function C independent of rt .

Consider
 Z t " ! #
 Z T 
exp − ru (rt )du B(t, T, rt ) = E exp − ru du  Ft .

0 0 
8 R. S. MAMON

Note that this is a P −martingale by the tower property. By Itô’s lemma,

we obtain
 Z t 
exp − ru (rt )du B(t, T, rt )
0
Z t  Z u 
= B(0, T, r0 ) + −ru exp − rv dv B(u, T, ru )du
0 0
Z t  Z u 
∂
+ exp − rv dv B(u, T, ru )du
0 0 ∂u
Z t  Z u 
∂
+ exp − rv dv B(u, T, ru )(a(b − ru )du + σdWu )
0 0 ∂ru
1 t
Z  Z u  2
∂
+ exp − rv dv 2
B(u, T, ru )σ 2 du.
2 0 0 ∂r u

Since this is a martingale, all the du terms must sum to zero. So,
∂ ∂
−rt B(t, T, rt ) + B(t, T, rt ) + B(t, T, rt )(a(b − rt ))
∂t ∂rt
σ2 ∂ 2
+ B(t, T, rt ) = 0. (16)
2 ∂rt2
Equation (16) is the PDE for the bond price in the Vasicek model. More-
over, this is a backward parabolic equation with B(T, T, rt ) = 1 for every
rt .
So far we know

B(t, T, rt ) = C(t, T )exp(−A(t, T )rt ).

Therefore, we get the following partial derivatives.

∂B ∂C ∂A
= exp(−A(t, T )rt ) − C rt exp(−A(t, T )rt )
∂t ∂t ∂t
∂B
= −ACexp(−A(t, T )rt )
∂rt
∂2B
= A2 Cexp(−A(t, T )rt )
∂rt2
So, substituting to the PDE in (16) we have
∂C ∂A
−rt Cexp(−Art ) + exp(−Art ) − C rt exp(−Art )
∂t ∂t
σ2 2
−ACexp(−Art )(a(b − rt )) + A Cexp(−Art ) = 0.
2
THREE WAYS TO SOLVE FOR BOND PRICES 9

Therefore,
∂C ∂A σ2 2
−rt C + −C rt − AC(a(b − rt )) + A C = 0.
∂t ∂t 2
Now, B(t, T, 0) = C(t, T ) and by putting rt = 0 we get
∂C σ2 2
− abAC + A C = 0.
∂t 2
Noting again that we are solving a backward ODE with C(T, T ) = 1, we
get
" #
ab T
Z T
σ2
Z
−a(T −u) −a(T −u) 2
C(t, T ) = exp − (1 − e )du + 2 (1 − e ) du
a t 2a t
σ2

b
= exp −b(T − t) + (1 − e−a(T −t) ) + 2 (T − t)
a 2a
2 2

σ −2a(T −t) σ −a(T −t)
+ 3 (1 − e ) − 3 (1 − e ) .
4a a
Write
D(t, T ) := log C(t, T ).
We see that this reconciles with the second to the last terms of equation
(12) and hence with the expression of equation (15). Under this approach,
we have
B(t, T, rt ) = exp(−A(t, T )rt + D(t, T ))
where A(t, T ) is given by (14).

4. Bond Pricing by HJM Methodology

Following the terminology and notation of Heath, Jarrow and Morton

(1992), this pricing paradigm is based on the concept of forward rate. The
instantaneous forward rate at time t for date T > t is defined by
∂ log B(t, t0 ) 

f (t, T ) = − . (17)
∂t0 0
t =T >t

This refers to the rate of interest that must be paid between t0 and T. It
is known at time t and therefore Ft −measurable. Solving the differential
equation in (17), yields
Z T !
B(t, T ) = exp − f (t, u)du . (18)
t
10 R. S. MAMON

The short rate at time t, rt , is the instantaneous rate at time t, i.e.,

rt = f (t, t) for every t ∈ [0, T ]. From equation (18), it is clear that once
f (t, T ) is completely determined the bond price immediately follows. The
dynamics of the forward rate and that of the short rate are related via the
forward measure. Invoking the insights of Geman, El Karoui and Rochet
(1995), the forward measure P T is defined on FT by setting
RT
dP T 

exp(− 0 ru du)
= ΛT := .
dP FT B(0, T, r0 )

Consider the Radon-Nikodým process

Rt
exp(− 0 ru du)B(t, T )
Λt := E[ΛT |Ft ] := , t ∈ [0, T ].
B(0, T )
For any FT −measurable random variable X we have
E T [X|Ft ] = Λt −1 E[X · ΛT |Ft ]
 R  
T

Xexp − t ru du 
= E  Ft  . (19)
B(t, T ) 


Now, the bond price in terms of the short rate is given by

" Z T ! #

B(t, T ) = E exp − ru du  Ft .

t 

Differentiating with respect to T, we get

" Z T ! #
∂B(t, T ) 
= E −rT exp − ru du  Ft = −E T [rT |Ft ]B(t, T ), (20)

∂T t 

where the last equality follows from (19) with X = rT . The bond price in
terms of the forward rate is given in equation (18). Thus, differentiating
B(t, T ) with respect to T, we obtain

∂B(t, T )
= −B(t, T )f (t, T ). (21)
∂T
Comparing (20) and (21), in terms of the short rate model, the forward
rate is given by
f (t, T ) = E T [rT |Ft ] (22)
where E T denotes the expectation under P T .
THREE WAYS TO SOLVE FOR BOND PRICES 11

Invoking the change of probability measures and numéraire technique,

under the forward measure P T , the stochastic dynamics for rt is given by
drt = (ab − A(t, T )σ 2 − art )dt + σdWtT , (23)
where WtT is the P T − Brownian motion defined by
dWtT = dWt + σA(t, T )dt,
and A(t, T ) is the function defined in equation (14). See Appendix for the
proof of (23). By Itô’s lemma, for t ≤ T, the solution to (23) is given by
σ2 σ2
 
rT = rt e−a(T −t) + b − 2 (1 − e−b(T −t) ) + 2 [e−a(T −t) − e−2a(T −t) ]
a 2a
Z T
+ σ e−a(T −u) dWuT .
t

Thus,
σ2
 
E u [ru |Ft ] = rt e−a(u−t) + b − 2 (1 − e−a(u−t) )
2a
2
σ
+ (e−a(u−t) − e−2a(u−t) ).
2a2
So,
T
σ2
Z  
u rt h −a(u−t) iT
E [ru |Ft ]du = −e + b − 2 (T − t)
t a t 2a
 2
 T
σ 1
− b− 2 − e−a(u−t)
2a a t
T T
σ2 2
 
−a(u−t) σ −2a(u−t)
+ − e − − e
2a3 4a3
t t
σ2

rt −a(T −t)
= (1 − e ) + b − 2 (T − t)
a 2a
2 −a(T −t)
σ2
  
σ 1−e
− b− 2 + 3 (1 − e−a(T −t) )
2a a 2a
2
σ
− 3 (1 − e−2a(T −t) )
4a
σ2
 
= rt A(t, T ) + b − 3 [(T − t) + A(t, T )]
2a
−a(T −t) 2
 
2 1−e
+σ .
a
12 R. S. MAMON

Therefore,
! !
Z T Z T
B(t, T, rt ) = exp − f (t, u)du = exp − E u [ru |Ft ]du
t t

= exp(−rt A(t, T ) + D(t, T ))

and the A(t, T ) and D(t, T ) values are in agreement with that of equations
(14) and (15), respectively.

5. Conclusion

The pedagogical value of the Vasicek model is well-known in stochastic

interest rate modeling. This paper contributes to the development of the
available mathematical techniques in obtaining the closed-form solution of
the bond price under the Vasicek framework. A discussion for each of the
three different methods was provided. The first derivation considers the
distributional properties of the short rate proces rt . The simple Gaussian
structure of rt leads to a closed-form solution of the bond price. The bond
price backward PDE is also derived using a martingale-oriented method-
ology. This PDE together with the Vasicek dynamics is the basis of the
second method which integrates ordinary differential equations to get the
bond price. Turning to the HJM pricing framework, the third approach
employs the dynamics of the forward rate to fully describe the bond price
process. The forward rate is linked to the short rate via the forward mea-
sure. When the short rate dynamics is determined under the forward mea-
sure, the HJM bond price is obtained and this reconciles with the prices
computed from the other two approaches.

Acknowledgments

The author wishes to thank an anonymous referee for many helpful

suggestions.

References

1. D. Duffie and R. Kan. A Yield-Factor Model of Interest Rates. Mathematical Fi-

nance, 64: 379-406, 1996.
2. R.J. Elliott and J. van der Hoek. Stochastic flows and the forward measure. Finance
and Stochastics, 5: 511-525, 2001.
THREE WAYS TO SOLVE FOR BOND PRICES 13

3. H. Geman, N. El Karoui and J. Rochet. Changes of Numéraire, Changes of Prob-

ability Measure and Option Pricing. Journal of Applied Probability, 32: 443-458,
1995.
4. D. Heath, R. Jarrow and A. Morton. Bond Pricing and the Term Structure of
Interest Rates: A New Methodology. Econometrica, 60: 77105, 1992.
5. I. Karatzas and S. Shreve. Brownian Motion and Stochastic Calculus. Springer
Verlag, Berlin-Heidelberg-New York, 1988.
6. D. Lamberton and B. Lapeyre. Introduction to Stochastic Calculus Applied to Fi-
nance. Chapman & Hall, London, 1995.
7. O. Vasicek. An Equilibrium characterization of the Term Structure. Journal of
Financial Economics, 5: 177-188, 1977.

Appendix : Proof of Result in Equation 23

Let P be an equivalent martingale measure (EMM) for the numéraire Ht

and Q an EMM for the numéraire Jt . Then for any VT ∈ L2 (Ω, FT , P ) and
VT ∈ L2 (Ω, FT , Q)
     
P Ht  Q Jt 
Vt := E VT Ft = E VT Ft .
HT  JT 

Assume that P and Q are equivalent and denote the Radon-Nikodým

derivative of Q with respect to P by Γt . We then have
     
Jt  Ht 
E Q VT Ft = E P
V T Γ t Ft .
JT  HT 

In particular, Γt = H Jt
Ht · JT for t < T. Suppose that the process under some
T

measure P associated with numéraire Ht is given by dXt = m(Xt , t)dt +

σ(Xt , t)dWt for some functions m(Xt , t) and σ(Xt , t). We are interested on
the process followed by Xt under another measure Q with numéraire Jt .
Q
Consider Γt,T = H Jt
Ht · JT . From Girsanov’s theorem, if Wt is a Wiener
T

t
process under Q, WtQ = WtP − 0 θu du where dΓt,T = Γt,T θT dWTP and θt
R

can be determined. Moreover, conditional upon Ft , Γt,T is a process in T.

Let Ht and Jt have dynamics under P given by

dHt = mH dt + σH dWtP and dJt = mJ dt + σJ dWtP .

Using these dynamics and noting that Γt is a martingale under P , it can

be verified that  
dΓT σJ σH
= − dWTP .
ΓT JT HT
14 R. S. MAMON

So, θt = σJJt − σHHt .

Applied to our current situation, suppose P is the EMM under the bank
account numéraire and Q is the forward measure with bond as the associ-
ated numéraire. For s < t < T
 Z t 
J t Hs B(t, T )
Γt := Γs,t = · = exp − ru du .
J s HT B(s, T ) s

Under measure P, dB(t,T )

B(t,T ) = rt dt + σB (t)dWt for some function σB (t).
It is a straightforward calculation to show that the process Γt = Γs,t ,
conditional upon Fs , satifies

dΓt dB(t, T )
= − rt dt = σB (t)dWt .
Γt B(t, T )
Rt
This implies that WtQ = WtP − 0 σB (u)du. Hence, if under P we have
the dynamics dXt = m(Xt , t)dt + σ(Xt , t)dWtP then the Q−process for Xt
is dXt = (m(Xt , t) + σB (t)σ(Xt , t))dt + σ(Xt , t)dWtQ .
Equation 23 follows from this result with X = r, Q = P T , σ(Xt , t) = σ,
σB (t) = −A(t, T )σ and m(Xt , t) = a(b − rt ).