Factors' correlation in the Heath–Jarrow–Morton interest rate model

Authors

  • Leonard Tchuindjo

    Corresponding author
    1. George Washington University, SEAS, 1776 G Street NW, Washington, DC 20052, U.S.A.
    2. Fannie Mae, Capital Market Pricing Group, 4000 Wisconsin Avenue NW, Washington, DC 20016, U.S.A.
    • Fannie Mae, Capital Market Pricing Group, 4000 Wisconsin Avenue NW, Washington, DC 20016, U.S.A.
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Abstract

We propose a new derivation of the Heath–Jarrow–Morton risk-neutral drift restriction that takes into account nonzero instantaneous correlations between factors. The result allows avoiding the orthogonalization of factors and provides an approach by which interest rate derivatives can be priced by preserving the economic meaning of each underlying factor. An application is given for the term structure of credit-risky bonds, driven by two correlated factors—the risk-free forward rate and the forward credit spreads. Copyright © 2008 John Wiley & Sons, Ltd.

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