Technical Note No.

31*
Options, Futures, and Other Derivatives
John Hull

Properties of Ho–Lee and Hull–White Interest Rate Models

This note presents some of the math underlying the Ho–Lee and Hull–White one-factor
models of the term structure. It follows the approach in Hull and White (1993).1
In a one-factor term structure, model the process for a zero-coupon bond price in the
traditional risk-neutral world must have a return equal to the short rate r. Suppose that
v(t, T ) is the volatility. Then:

dP (t, T ) = rP (t, T )dt + v(t, T )P (t, T )dz (1)

In this note, we will assume that v is a function only of t and T . Because the bond’s price
volatility declines to zero at maturity v(t, t) = 0.
From Ito’s lemma, for any times T1 and T2 with T2 > T1

v(t, T1 )2
 
d ln P (t, T1 ) = r − dt + v(t, T1 )dz(t) (2)
2

v(t, T2 )2
 
d ln P (t, T2 ) = r − dt + v(t, T2 )dz(t) (3)
2
Define f (t, T1 , T2 ) as the forward rate for the period between time T1 and T2 as seen at
time t
ln P (t, T2 ) − ln P (t, T1 )
f (t, T1 , T2 ) = −
T2 − T1
From equations (2) and (3)

v(t, T2 )2 − v(t, T1 )2
   
v(t, T2 ) − v(t, T1 )
df (t, T1 , T2 ) = dt − dz(t)
2(T2 − T1 ) T2 − T1

Define R(t, T ) as the zero rate for the period between t and T .
Z T
R(t, T ) = f (0, t, T ) + df (τ, t, T )
0

so that
Z t Z t
v(τ, T )2 − v(τ, t)2
 
v(τ, T ) − v(τ, t)
R(t, T ) = f (0, t, T ) + dτ − dz(τ ) (4)
0 2(T − t) 0 T −t

* c Copyright John Hull. All Rights Reserved. This note may be reproduced for use in
conjunction with Options, Futures, and Other Derivatives by John C. Hull.
1
See J. Hull and A. White , “Bond Option Pricing Based on a Model for the Evolution
of Bond Prices,” Advances in Futures and Options Research, 6 (1993), 1–13.

1
As T approaches t, R(t, T ) becomes r(t) and f (0, t, T ) becomes the instantaneous forward
rate, F (0, t) so that
t t
∂ v(τ, t)2
Z Z
∂
r(t) = F (0, t) + dτ − v(τ, t) dz(τ )
0 ∂t 2 0 ∂t
or Z t Z t
r(t) = F (0, t) + v(τ, t)vt (τ, t)dτ − vt (τ, t)dz(τ ) (5)
0 0

where subscripts denote partial derivatives. To calculate the process for r we differentiate
with respect to t. Because v(t, t) = 0, this gives
 Z t Z t 
2
dr = Ft (0, t) + [v(τ, t)vtt (τ, t) + vt (τ, t) ]dτ − vtt (τ, t)dz(τ ) dt − vt (τ, t)|τ =t dz(t)
0 0
(6)

Case 1: Ho–Lee; v(t, T ) = σ(T − t)

In the case, equation (5) gives
Z t
2 2
r(t) = F (0, t) + σ t /2 − σ dz(τ ) (7)
0

and equation (6) gives

dr(t) = [Ft (0, t) + σ 2 t]dt + σ dz
This is the Ho-Lee model
dr = θ(t) dt + σ dz
We have proved the equation for θ(t)

θ(t) = Ft (0, t) + σ 2 t

Also from equation (4)

Z t
2
R(t, T ) = f (0, t, T ) + σ tT /2 − σ dz(τ ) (8)
0

From equations (7) and (8)

R(t, T ) = f (0, t, T )+σ 2 tT /2+r(t)−F (0, t)−σ 2 t2 /2 = f (0, t, T )−F (0, t)+σ 2 t(T −t)/2+r(t)

Because
ln P (t, T ) = −R(t, T )(T − t)
It follows that

ln P (t, T ) = −f (0, t, T )(T − t) + F (0, t)(T − t) − σ 2 t(T − t)2 /2 − r(t)(T − t)

2
The forward bond price P (0, T )/P (0, t) equals e−f (0,t,T )(T −t) so that this becomes

P (0, T )
ln P (t, T ) = ln + F (0, t)(T − t) − σ 2 t(T − t)2 /2 − r(t)(T − t)
P (0, t)

This proves:
P (t, T ) = A(t, T )e−r(t)(T −t)
where
P (0, T ) 1
ln A(t, T ) = ln + F (0, t)(T − t) − σ 2 t(T − t)2
P (0, t) 2

Case 2: Hull–White; v(t, T ) = σ(1 − e−a(T −t) )/a

In this case, equation (5) gives
t
σ2 σ2
Z
r(t) = F (0, t) + 2 (1 − e−at ) − 2 (1 − e−2at ) − σe−a(t−τ ) dz(τ ) (9)
a 2a 0

Equation (6) gives

t
σ 2 −at
 Z 
dr(t) = Ft (0, t) + (e − e−2at ) + σae−a(t−τ )
dz(τ ) dt − σ dz(t) (10)
a 0

Substituting for Z t
σe−a(t−τ )dz(τ )
0

from equation (9) into equation (10) we obtain

σ 2 −at σ2 σ2
 
−2at −at −2at
dr(t) = Ft (0, t) + (e −e ) − ar(t) + aF (0, t) + (1 − e ) − (1 − e ) dt−σ dz(t)
a a 2a
or
σ2
 
−2at
dr(t) = Ft (0, t) + aF (0, t) − ar(t) + (1 − e ) dt − σ dz(t)
2a
This is the Hull–White model

dr(t) = (θ(t) − ar) dt + σ dz

with
σ2
θ(t) = Ft (0, t) + aF (0, t) + (1 − e−2at )
2a
From equation (4)

σ 2 [e−2a(T −t) − e−2aT − 1 + e−2at − 4e−a(T −t) + 4e−aT + 4 − 4e−at ]

R(t, T ) = f (0, t, T ) +
4a3 (T − t)

3
 t
σ(e−aT − e−at )
Z
+ eaτ dz(τ ) (11)
a(T − t) 0

From equation (9)

t
σ 2 at σ 2 at
Z
σ eaτ dz(τ ) = −r(t)eat + F (0, t)eat + (e − 1) − (e − e−at )
0 a2 2a2

so that

σ 2 [e−2a(T −t) − e−2aT − 1 + e−2at − 4e−a(T −t) + 4e−aT + 4 − 4e−at ]

R(t, T ) = f (0, t, T ) +
4a3 (T − t)

(e−aT − e−at ) σ 2 at σ 2 at
 
at at −at
+ −r(t)e + F (0, t)e + 2 (e − 1) − 2 (e − e )
a(T − t) a 2a
Now
ln P (t, T ) = −R(t, T )(T − t)
and the forward bond price P (0, T )/P (0, t) equals e−f (0,t,T )(T −t) . After some tedious
algebra we get

P (0, T ) 1
ln P (t, T ) = ln + F (0, t)B(t, T ) − 3 σ 2 (e−aT − e−at )2 (e2at − 1) − r(t)B(t, T )
P (0, t 4a

where
1 − e−a(T −t) )
B(t, T ) =
a
showing that
P (t, T ) = A(t, T )e−B(t,T )r
where

P (0, T ) 1
ln A(t, T ) = ln + F (0, t)B(t, T ) − 3 σ 2 (e−aT − e−at )2 (e2at − 1)
P (0, t 4a

4
Bond Options
Consider a European option with strike price K and maturity T on a zero-coupon
bond where the maturity of the bond is s. The forward price of the bond underlying the
option as seen at time t, FB (t, T, s), is

P (t, s)
FB (t, T, s) =
P (t, T )

Using the results in equations (2) and (3) we get

v(t, T )2 − v(t, s)2

d ln FB (t, T, s) = dt + [v(t, s) − v(t, T )] dz
2

This shows that the P (T, s) = fB (T, T, s) is lognormal when v(t, T ) is function only of t
and T . The variance ln P (T, s) is then
Z T
σP2 = [v(t, s) − v(t, T )]2 dt
0

In the case of Ho-Lee v(t, T ) = σ(T − t) and σP2 = σ 2 (s − T )2 T . In Hull-White

v(t, T ) = σB(t, T ) so that

T
σ2
Z
σP2 =σ 2
[B(t, s) − B(t, T )]2 dt = [1 − e−a(s−T ) ]2 (1 − e−2aT )
0 2a3

In both cases bond options can be valued using Black’s model. The average variance rate
of the forward bond price is σP2 /T . This leads to the results for bond options in the text.