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The Heath–Jarrow–Morton (HJM) framework is a general framework to model the evolution of
interest rate An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, ...
curves – instantaneous forward rate curves in particular (as opposed to simple
forward rate The forward rate is the future yield on a bond. It is calculated using the yield curve. For example, the yield on a three-month Treasury bill six months from now is a ''forward rate''.. Forward rate calculation To extract the forward rate, we ...
s). When the volatility and drift of the instantaneous forward rate are assumed to be deterministic, this is known as the Gaussian Heath–Jarrow–Morton (HJM) model of forward rates. For direct modeling of simple forward rates the Brace–Gatarek–Musiela model represents an example. The HJM framework originates from the work of David Heath,
Robert A. Jarrow __NOTOC__ Robert Alan Jarrow is the Ronald P. and Susan E. Lynch Professor of Investment Management at the Cornell Johnson Graduate School of Management. Professor Jarrow is a co-creator of the Heath–Jarrow–Morton framework for pricing inte ...
, and Andrew Morton in the late 1980s, especially ''Bond pricing and the term structure of interest rates: a new methodology'' (1987) – working paper,
Cornell University Cornell University is a Private university, private Ivy League research university based in Ithaca, New York, United States. The university was co-founded by American philanthropist Ezra Cornell and historian and educator Andrew Dickson W ...
, and ''Bond pricing and the term structure of interest rates: a new methodology'' (1989) – working paper (revised ed.), Cornell University. It has its critics, however, with
Paul Wilmott Paul Wilmott (born 8 November 1959) is an English people, English researcher, consultant and lecturer in quantitative finance.istakesto be swept under".''Newsweek'' 2009
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Framework

The key to these techniques is the recognition that the drifts of the no-arbitrage evolution of certain variables can be expressed as functions of their volatilities and the correlations among themselves. In other words, no drift estimation is needed. Models developed according to the HJM framework are different from the so-called
short-rate model A short-rate model, in the context of interest rate derivatives, is a mathematical model that describes the future evolution of interest rates by describing the future evolution of the short rate, usually written r_t \,. The short rate Under a sh ...
s in the sense that HJM-type models capture the full dynamics of the entire forward rate curve, while the short-rate models only capture the dynamics of a point on the curve (the short rate). However, models developed according to the general HJM framework are often non- Markovian and can even have infinite dimensions. A number of researchers have made great contributions to tackle this problem. They show that if the volatility structure of the forward rates satisfy certain conditions, then an HJM model can be expressed entirely by a finite state Markovian system, making it computationally feasible. Examples include a one-factor, two state model (O. Cheyette, "Term Structure Dynamics and Mortgage Valuation", ''Journal of Fixed Income,'' 1, 1992; P. Ritchken and L. Sankarasubramanian in "Volatility Structures of Forward Rates and the Dynamics of Term Structure", ''Mathematical Finance'', 5, No. 1, Jan 1995), and later multi-factor versions.


Mathematical formulation

The class of models developed by Heath, Jarrow and Morton (1992) is based on modelling the forward rates. The model begins by introducing the instantaneous forward rate \textstyle f(t,T), \textstyle t \leq T, which is defined as the continuous compounding rate available at time \textstyle T as seen from time \textstyle t. The relation between bond prices and the forward rate is also provided in the following way: :P(t,T) = e^ Here \textstyle P(t,T) is the price at time \textstyle t of a zero-coupon bond paying $1 at maturity \textstyle T\geq t. The risk-free money market account is also defined as :\beta(t) = e^ This last equation lets us define \textstyle f(t,t) \triangleq r(t), the risk free short rate. The HJM framework assumes that the dynamics of \textstyle f(t,s) under a risk-neutral pricing measure \textstyle \mathbb Q are the following: :df(t,s) = \mu(t,s)dt + \boldsymbol \sigma(t,s) dW_t Where \textstyle W_t is a \textstyle d-dimensional
Wiener process In mathematics, the Wiener process (or Brownian motion, due to its historical connection with Brownian motion, the physical process of the same name) is a real-valued continuous-time stochastic process discovered by Norbert Wiener. It is one o ...
and \textstyle \mu(u,s), \textstyle \boldsymbol \sigma(u,s) are \textstyle \mathcal F_u adapted processes. Now based on these dynamics for \textstyle f, we'll attempt to find the dynamics for \textstyle P(t,s) and find the conditions that need to be satisfied under risk-neutral pricing rules. Let's define the following process: :Y_t \triangleq \log P(t,s) = -\int_t^s f(t,u) du The dynamics of \textstyle Y_t can be obtained through Leibniz's rule: :\begin dY_t &= f(t,t) dt - \int_t^s df(t,u) du \\ &= r_t dt - \int_t^s \mu(t,u) dt du - \int_t^s \boldsymbol \sigma(t,u) dW_t du \end If we define \textstyle \mu(t,s)^* = \int_t^s \mu(t,u) du, \textstyle \boldsymbol \sigma(t,s)^* = \int_t^s \boldsymbol \sigma(t,u) du and assume that the conditions for Fubini's Theorem are satisfied in the formula for the dynamics of \textstyle Y_t, we get: : dY_t = \left( r_t - \mu(t,s)^* \right)dt - \boldsymbol \sigma(t,s)^* dW_t By Itō's lemma, the dynamics of \textstyle P(t,T) are then: :\frac = \left( r_t - \mu(t,s)^* + \frac \boldsymbol \sigma(t,s)^* \boldsymbol \sigma(t,s)^ \right)dt - \boldsymbol \sigma(t,s)^* dW_t But \textstyle \frac must be a martingale under the pricing measure \textstyle \mathbb Q, so we require that \textstyle \mu(t,s)^* = \frac \boldsymbol \sigma(t,s)^* \boldsymbol \sigma(t,s)^ . Differentiating this with respect to \textstyle s we get: :\mu(t,u) = \boldsymbol \sigma(t,u) \int_t^u \boldsymbol \sigma(t,s)^ ds Which finally tells us that the dynamics of \textstyle f must be of the following form: :df(t,u) = \left( \boldsymbol \sigma(t,u) \int_t^u \boldsymbol \sigma(t,s)^ ds \right) dt + \boldsymbol \sigma(t,u) dW_t Which allows us to price bonds and interest rate derivatives based on our choice of \textstyle \boldsymbol \sigma .


See also

* Black–Derman–Toy model * Brace–Gatarek–Musiela model * Chen model * Cheyette model * Ho–Lee model * Hull–White model


References


Notes


Sources

* Heath, D., Jarrow, R. and Morton, A. (1990)
Bond Pricing and the Term Structure of Interest Rates: A Discrete Time Approximation
'' Journal of Financial and Quantitative Analysis'', 25:419-440. * Heath, D., Jarrow, R. and Morton, A. (1991)
Contingent Claims Valuation with a Random Evolution of Interest Rates
. '' Review of Futures Markets'', 9:54-76. * Heath, D., Jarrow, R. and Morton, A. (1992)
Bond Pricing and the Term Structure of Interest Rates: A New Methodology for Contingent Claims Valuation
''
Econometrica ''Econometrica'' is a peer-reviewed academic journal of economics, publishing articles in many areas of economics, especially econometrics. It is published by Wiley-Blackwell on behalf of the Econometric Society. The current editor-in-chief is ...
'', 60(1):77-105. * Robert Jarrow (2002). ''Modelling Fixed Income Securities and Interest Rate Options'' (2nd ed.). Stanford Economics and Finance.


Further reading


Non-Bushy Trees For Gaussian HJM And Lognormal Forward Models
Prof Alan Brace,
University of Technology Sydney The University of Technology Sydney (UTS) is a public university, public research university located in Sydney, New South Wales, Australia. The university was founded in its current form in 1988, though its origins as a Institute of technology, ...

The Heath-Jarrow-Morton Term Structure Model
, Prof. Don Chance E. J. Ourso College of Business,
Louisiana State University Louisiana State University and Agricultural and Mechanical College, commonly referred to as Louisiana State University (LSU), is an American Public university, public Land-grant university, land-grant research university in Baton Rouge, Louis ...

Recombining Trees for One-Dimensional Forward Rate Models
Dariusz Gatarek, Wyższa Szkoła Biznesu – National-Louis University, and Jaroslaw Kolakowski
Implementing No-Arbitrage Term Structure of Interest Rate Models in Discrete Time When Interest Rates Are Normally Distributed
Dwight M Grant and Gautam Vora. '' The Journal of Fixed Income'' March 1999, Vol. 8, No. 4: pp. 85–98
Heath–Jarrow–Morton model and its application
Vladimir I Pozdynyakov,
University of Pennsylvania The University of Pennsylvania (Penn or UPenn) is a Private university, private Ivy League research university in Philadelphia, Pennsylvania, United States. One of nine colonial colleges, it was chartered in 1755 through the efforts of f ...

An Empirical Study of the Convergence Properties of the Non-recombining HJM Forward Rate Tree in Pricing Interest Rate Derivatives
A.R. Radhakrishnan
New York University New York University (NYU) is a private university, private research university in New York City, New York, United States. Chartered in 1831 by the New York State Legislature, NYU was founded in 1832 by Albert Gallatin as a Nondenominational ...
* Modeling Interest Rates with Heath, Jarrow and Morton. Dr Donald van Deventer, Kamakura Corporation:
With One Factor and Maturity-Dependent Volatility

With One Factor and Rate and Maturity-Dependent Volatility

With Two Factors and Rate and Maturity-Dependent Volatility

With Three Factors and Rate and Maturity-Dependent Volatility
{{DEFAULTSORT:Heath-Jarrow-Morton framework Financial models Mathematical finance Fixed income analysis