Forward rate dependent Markovian transformations of the Heath-Jarrow-Morton term structure model (Q5936316): Difference between revisions

In the risk neutral Heath-Jarrow-Morton (HJM) term structure model, evolution of the forward rate process is completely determined by the forward rate volatilities. The HJM framework is very general and contains many of the earlier interest rate models as special cases. One drawback of the generality, from a practical perspective, is that the model is non-Markovian in general and consequently does not readily lend itself to efficient solution techniques. Suitable restrictions on volatility processes led many authors to transform the HJM model to finite-dimensional Markovian systems. The model by \textit{R. Bhar} and \textit{C. Chiarella} [Europ. J. Finance 3, 1-26 (1997)] has the feature that spot rate volatility may be an arbitrary function of the spot rate and although the Markovian systems of \textit{P. Ritchken} and \textit{L. Sankarasubramanian} [Math. Finance 5, No. 1, 55-72 (1995; Zbl 0866.90023)] and \textit{K. Inui} and \textit{M. Kijima} [J. Financ. Quant. Anal. 33, No. 3, 423-440 (1998)] have the same feature, the bond price formulae obtained therein apply to a more general class of volatility processes, such as those which depend on a finite number of fixed tenor forward rates. In each case, the forward rate volatility processes are expressible as a product of the spot rate volatility and a path-dependent function. These models, however, overlap only for a small set of volatility processes. In this paper a common generalization of the above models is obtained, in which the multifactor HJM model is transformed to a finite-dimensional Markovian system, and, in particular, a multifactor generalization of the \textit{K. Inui} and \textit{M. Kijima} (loc. cit.) model is obtained. Further, the volatility processes in the generalized models are allowed to be arbitrary functions of a finite number of fixed tenor forward rates. Consequently, they include finite-dimensional forward rate dependent Markovian transformations of the multifactor HJM model. Once a finite-dimensional Markovian representation is established, derivative prices can be obtained either by solving the PDE, obtained through the application of the Feynman-Kac theorem, or by Monte Carlo simulation. As a general rule, it is convenient to apply the PDE approach for low dimensional systems, and to use the Monte Carlo methods for higher dimensional characterizations. Some numerical implementations of the models presented in this paper are mentioned.