Effect of correlation on bond prices in short rate models of interest rates

Zuzana Girová, Beáta Stehíková

Short rate models of interest rates are formulated in terms of stochastic differential equations which describe the evoution of an instantaneous interest rate, called short rate. Bonds and other interest rate derivatives are then priced by a parabolic partial differential equation. We consider two-factor models, in which also correlation between the factors enters the bond-pricing differential equation. Firstly, we study the dependence of the bond prices on the correlation in three particular short rate models. The differences and common features of the results motivate us to investigate the dependence of the solution to the bond-pricing partial differential equation on the parameter representing correlation between the factors in a general case.