State Variables and the Affine Nature of Markovian HJM Term Structure Models

Carl Chiarella and Oh-Kang Kwon

No 52, Research Paper Series from Quantitative Finance Research Centre, University of Technology, Sydney

Abstract: Finite dimensional Markovian HJM term structure models provide an ideal setting for the study of term structure dynamics and interest rate derivatives where the flexibility of the HJM framework and the tractability of Markovian models coexist. Consequently, these models became the focus of a series of papers including Carverhill (1994), Ritchken and Sankarasuramanian (1995), Bhar and Chiarella (1997), Inui and Kijima (1998) and de Jong and Santa-Clara (1999). In Chiarella and Kwon (2001b), a common generalisation of these models was obtained in which the components of the forward rate volatility process satisfied ordinary differential equations in the maturity variable. However, the generalised models require the introduction of a large number of state variables which, at first sight, do not appear to have clear links to market observed quantities. In this paper, it is shown that the forward rate curves for these models can often be expressed as affine functions of the state variables, and conversely that the state variables in these models can often be expressed as affine functions of a finite number of benchmark forward rates. Consequently, for these models, the entire forward rate curve is not only Markov but affine with respect to a finite number of benchmark forward rates. It is also shown that the forward rate curve can be expressed as an affine function of a finite number of yields which are directly observed in the market. This property is useful, for example, in the estimation of model parameters. Finally, an explicit formula for the bond price in terms of the state variables, generalising the formula given in Inui and Kijima (1998), is provided for the models considered in this paper.

Pages: 17 pages
Date: 2001-06-01
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Citations: View citations in EconPapers (2)

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