[Math] Variance of the Cox Ingersoll Ross model

stochastic-calculus

Consider the Cox-Ingersoll-Ross (CIR) interest rate model: $\displaystyle d r_t = \kappa (\theta – r_t) \, d t + \sigma \sqrt{r_t} \,d W_t$ where $\kappa$, $\theta$, $\sigma$ are positive constants and $W_t$ is a standard Brownian motion.

A solution to the CIR stochastic differential equation is given by:
$$ r_t = \theta + (r_0 – \theta) e^{-\kappa t} + \sigma e^{-\kappa t} \int_0^t e^{\kappa u} \sqrt{r_u} \,d W_u.$$

Since $\displaystyle d W_u \sim N(0, du)$ it is easy to derive that:

$$\mathrm{E}\left[r_t\right] = \theta + (r_0 – \theta) e^{-\kappa t}.$$

However, I am stuck on deriving the variance. I got as far as below. Anyone know how to solve for the variance?

Thanks.

My derivation so far:

$$ \operatorname{Var}\left[r_t\right] = \mathrm{E}\left[\left\{r_t – \mathrm{E}\left(r_t\right)\right\}^2\right] = \sigma^2 e^{-2 \kappa t} \mathrm{E}\left[\left\{\int_0^t e^{\kappa u} \sqrt{r_u} d W_u\right\}^2\right].$$

What to do with the square of that integral? The solution I found states:

$$ \sigma^2 e^{-2 \kappa t} \mathrm{E}\left[\left\{\int_0^t e^{\kappa u} \sqrt{r_u} \,d W_u\right\}^2\right] = \sigma^2 e^{-2 \kappa t} \int_0^t e^{2 \kappa u} \mathrm{E}\left(r_u\right) \,d u$$

and continues onwards from here. But I don't get how you can take the square inside the integral.

Best Answer

The last equality $$ \sigma^2 \mathrm{e}^{-2 \kappa t} \mathrm{E}\left[\left\{\int_0^t \mathrm{e}^{\kappa u} \sqrt{r_u} \,d W_u\right\}^2\right] = \sigma^2 \mathrm{e}^{-2 \kappa t} \int_0^t \mathrm{e}^{2 \kappa u} \mathrm{E}\left(r_u\right) \,d u $$ follows by Ito isometry property of Ito integrals.