Consistency problems for Heath-Jarrow-Morton interest rate models (Q5931585)

The Heath-Jarrow-Morton approach to the modeling of the forward curve (the term structure of forward rates) was a significant progress in the pricing of fixed-income products because, basically, it unifies all continuous interest rate models. The forward curve cannot be observed on the market and therefore has to be estimated. The most common curve-fitting methods can be represented as a parametrized family of smooth curves \({\mathcal{G}}=\{ G(. ,z): z \in {\mathcal{Z}}\}\) with some finite dimensional parameter set \({\mathcal{Z}}\). This monograph is an excellent and thorough review of the current work in the study of consistent (arbitrage free) stochastic models for \(z\). The author presents a systematic study of this consistency problem in a very general framework that includes many known results as well as some new insights and challenging open questions. The book provides a brief introduction to infinite dimensional stochastic analysis in order to present the Heath-Jarrow-Morton methodology in a functional analytic framework that incorporates an infinite-dimensional driving Brownian motion. The Musiela parametrization leads to a stochastic equation in a Hilbert space \(H\) that describes the arbitrage-free evolution of the forward curve. In this setting, the family \({\mathcal G}\) is just a subset of \(H\) and the consistency considerations are transformed into a stochastic invariance problem. Some general results on stochastic invariance for finite dimensional submanifolds in a Hilbert space are deduced. They are then applied to the classical estimation methods.