Finite dimensional affine realisations of HJM models in terms of forward rates and yields (Q1421716)

The HJM term structure model is a SDE of the forward rate which provides a general framework for pricing the interest rate derivatives. However, the Markovian HJM model is more attractive. Unfortunately, generally a number of unclear state variables are involved as auxillary variables in the Markovian HJM models. An affine HJM model with a finite realization is that the forward rate \(r(t,x)\) can be expressed by a linear function (with coeffficients depending on \((t,x)\)) of a process \(z(t)\), which satisfies an Itô equation. In the present paper, these auxillary state variables are shown to be related to market observed quantities by assuming that the volatility is a function of a finite number of forward rates with different maturity and the volatility also satisfies a homogeneous linear ODE with deterministic coefficients. Under these assuptions, it is proven that the forward rate is affine with this finite number of forward rates with different maturity to be \(z(t)\), and the zero coupon bond prices and yields have closed form formulae. The extended Vasicek model with \(\sigma (t,x)= \sigma_0e^{-\kappa (x-t)}\), the Richken-Sankarasubramanian model with \(\sigma (t,x)= g(t,r(t))\sigma_0^{-\int_t^x \kappa (u)\,du}\), the HJM model with hamped volatility \(\sigma (t,x)= r^{\lambda}(t)[\beta_0 +\beta_1(x-t)]e ^{-\kappa (x-t)}\) and a three-dimensional HJM model are surveyed as examples. The model calibration and other relationships are also discussed.