Equivalence of interest rate models and lattice gases

Abstract

We consider the class of short rate interest rate models for which the short rate is proportional to the exponential of a Gaussian Markov process x(t) in the terminal measure r(t)=a(t)exp[x(t)]. These models include the Black-Derman-Toy and Black-Karasinski models in the terminal measure. We show that such interest rate models are equivalent to lattice gases with attractive two-body interaction, V(t(1),t(2))=-Cov[x(t(1)),x(t(2))]. We consider in some detail the Black-Karasinski model with x(t) as an Ornstein-Uhlenbeck process, and show that it is similar to a lattice gas model considered by Kac and Helfand, with attractive long-range two-body interactions, V(x,y)=-α(e(-γ|x-y|)-e(-γ(x+y))). An explicit solution for the model is given as a sum over the states of the lattice gas, which is used to show that the model has a phase transition similar to that found previously in the Black-Derman-Toy model in the terminal measure.