Short Rate Models: Hull-White or Black-Karasinski?Implementation Note and Model Comparison for ALM

In this paper, we compare two one-factor short rate models: the Hull White model and the Black-Karasinski model. Despite their inherent shortcomings the short rate models are being used quiteextensively by the practitioners for risk-management purposes. The research, as part of students’projects in collaboration with the Asset-Liability-Management (ALM) Group of ABN AMRO Bank,provides detail procedures on the implementation, and assesses model performance from an ALMperspective. In particular, we compare the two models for pricing and hedging Bermudanswaptions because of its resemblance to prepayment option in typical mortgage loans. To ourknowledge, the implementation of the two short rate models (and the Black-Karasinski model inparticular) is not well documented. We implemented the two models using interest rate derivativeson Euro and US rates over the period February 2005 to September 2007 and with the Hull-Whitetrinomial tree. Our results show that in terms of the in-sample pricing tests, the one-factor Hull-White model outperforms the Black-Karasinski model....