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 /ref>
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 , , which is defined as the continuous compounding rate available at time as seen from time . The relation between bond prices and the forward rate is also provided in the following way:
:
Here is the price at time of a zero-coupon bond paying $1 at maturity . The risk-free money market account is also defined as
:
This last equation lets us define , the risk free short rate. The HJM framework assumes that the dynamics of under a risk-neutral pricing measure are the following:
:
Where is a -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 , are adapted processes. Now based on these dynamics for , we'll attempt to find the dynamics for and find the conditions that need to be satisfied under risk-neutral pricing rules. Let's define the following process:
:
The dynamics of can be obtained through Leibniz's rule:
:
If we define , and assume that the conditions for Fubini's Theorem are satisfied in the formula for the dynamics of , we get:
:
By Itō's lemma, the dynamics of are then:
:
But must be a martingale under the pricing measure , so we require that . Differentiating this with respect to we get:
:
Which finally tells us that the dynamics of must be of the following form:
:
Which allows us to price bonds and interest rate derivatives based on our choice of .
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.
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, ...
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 ...
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 ...
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 ...