DEFINITION of 'Hull–White Model'

A single-factor interest model used to price derivatives. The Hull-White model assumes that short rates have a normal distribution, and that the short rates are subject to mean reversion. Volatility is likely to be low when short rates are near zero, which is reflected in a larger mean reversion in the model. The Hull-White model extends the Vasicek and Cox-Ingersoll-Ross (CIR) models.

BREAKING DOWN 'Hull–White Model'

Investments whose values are dependent on interest rates, such as bond options and mortgage-backed securities, have grown in popularity as financial systems have become more sophisticated. Determining the value of these investments often entailed using different models, with each model having its own set of assumptions. This made it difficult to match the volatility parameters of one model with another model, and also made it difficult to understand risk across a portfolio of different investments.

Like the Ho-Lee model, the Hull-White model treats interest rates as normally distributed. This creates a scenario in which interest rates are negative, though there is a low probability of this occurring as a model output. The Hull-White model also prices the derivative as a function of the entire yield curve, rather than at a single point. Because the yield curve estimates future interest rates rather than observable market rates, analysts will hedge against different scenarios that economic conditions might create.

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