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Heath Jarrow Morton a interest rate

model for CVA calculations


For

Management staff Development


Alexis Maenhout 14/06/2013

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Contents
1

Context:....................................................................................................... 3

Introduction:.................................................................................................. 3
2.1

A real world model.....................................................................................3

2.2

A Risk neutral model for (derivative) pricing.......................................................4

2.3

Multidimensional approach............................................................................6

2.4

Observing Parameters..................................................................................7

2.5

Volatility functions.....................................................................................8

2.6

Practical aspects of Monte Carlo Simulation.......................................................8

2.6.1

Interpolation algorithm..........................................................................8

2.6.2

Numerical integration............................................................................8

2.6.3

Principal component analysis...................................................................8

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Context:

Contrarily to what one might expect Heath Jarrow Morton is more a frame work than an n-th
model next to other short rate models. For a start it is not a short rate model but an instantaneous
forward rate model. Precisely to opt for the forward rate as fundamental quantity to model they
provided an arbitrage free frame work for the stochastic evolution of the forward curve whereby
the forward rate dynamics are fully specified by instantaneous volatility structures.

Introduction:
2.1 A real world model

First consider pricing a zero-bond paying 1 unit of currency at maturity based on the instantaneous
forward rate

F ( t , T ) . This is the rate observed at time t

paid at time

in the future.

(2.1)

F (t , v ) dv
t

Z ( t , T )=exp
Using Leibniz rule for differentiating integrals we obtain a basic expression for the forward rate.

F ( t , T )=

(2.2)

ln Z ( t ,T )
T

We can obtain the differentiation for this forward rate:

dF ( t ,T )=d

(2.3)

ln Z ( t ,T )
T

that we can manipulate this expression by displacing the minus sign and by interchanging the
partial differentiation towards the T maturity with the total differentiator

d ( . ) . The latter is

possible regarding the fact that T must be seen as a parameter and not as a variable in this
context.

dF ( t ,T )=

d ( ln Z ( t , T ) )
T

Let us now concentrate on our zero-bond

(2.4)

Z , we can also assign it a stochastic model to

describe its evolution. Herein T is parametric so

d ( . ) is a variation of t keeping the maturity T

as fixed!

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(2.5)

dZ ( t , T )= ( t ,T ) Z ( t , T ) dt+ ( t , T ) Z ( t , T ) dX

This is nothing else than a single factor model, very much looking like a log normal random

Z ( t , t )=1 this automatically implies ( t , t )=0 !

variable.... Notice that by definition

Applying Its differentiating lemma for a stochastic variable

W =W ( Z )=ln Z , keeping in mind

lim dX =dt
t0

magnitude

and that the product of stochastic differentials can be neglected by order of

dtdX < dt ; dt 2 0 we obtain

dW ( Z ) =

(2.6)

W
1 2W
dZ +
dZ 2
2
Z
2 Z

With Its lemma Error: Reference source not found worked out based on Error: Reference source
not found we get :

d ln ( Z )=

1
1
1
2 2 (2.7)
(
)
( ( t , T ) Z ( t , T ) dt + ( t ,T ) Z (t ,T ) dX ) +

t
,
T
Z ( t , T ) dt
2 Z 2 ( t ,T )
Z (t , T )

After rearranging:
(2.8)

1
d ln ( Z )= ( t , T ) ( t , T )2 dt+ ( t ,T ) dX
2

Substitute this result in our forward rate expression Error: Reference source not found to obtain a
real world SDE to describe the forward curve evolution

dF ( t ,T )=

( t ,T ) ( t , T )2 dt
( t ,T ) dX
T
2
T

(2.9)

2.2 A Risk neutral model for


(derivative) pricing
In order to derive the risk neutral world we can start by looking how a hedged portfolio behaves.
While we are still in a one factor model where we assume all maturities are perfectly correlated.
We observe a portfolio of a bond hedged by another maturity bond.

=Z ( t , T 1 ) Z ( t , T 2 )

(2.10)

Observing the portfolio evolution:

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(2.11)

d =dZ ( t , T 1 ) dZ ( t , T 2 )
And substituting Error: Reference source not found while choosing delta

as an amount of

hedging bonds:

( t , T 1) Z ( t ,T 1 )
( t , T 2) Z ( t ,T 2 )

(2.12)

We set this portfolio evolution equal to its riskless return

( t ,T 1 )r
(t , T1)

( t ,T 2 )r
( t , T2)

d =r dt

and rearrange to obtain

(2.13)

This is only possible if both sides are independent of the bond maturity and thus the market price
of risk

( t ) is independent of the maturity


( t , T ) =r ( t ) + ( t ) ( t ,T )

(2.14)

Here from we see that the market price of risk must be zero for a risk neutral world where;

( t , T ) =r ( t )
In other words the expected return on any traded investment should be the riskless rate

(2.15)

r (t ) .

This leads us to a new SDE for a riskless bond evolution very much like Error: Reference source not
found

dZ ( t , T )=r ( t ) Z ( t , T ) dt + ( t , T ) Z ( t , T ) dX

(2.16)

Now let us rewrite our forward rate evolution SDE Error: Reference source not found as follows

dF ( t ,T )=m ( t , T ) dt + ( t ,T ) dX

(2.17)

Based on the second term of Error: Reference source not found we easily recognize herein the
forward rate volatility

( t , T )=

( t ,T )
T

(2.18)

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( t , t )=0 we get, leaving the constant of integration zero:

After integration and respecting

(2.19)

( t , T )= ( t , v ) dv
t

Based on the first term of Error: Reference source not found we obtain the forward rate drift:

m ( t ,T )=

1
( t ,T )2 ( t , T )
T 2

(2.20)

Applying the partial derivation towards the maturity and forward rate volatility definition:

m ( t ,T )= (t ,T )

( t ,T )
( t ,T )
T
T

m ( t ,T )= ( t , v ) dv ( ( t , T ))
t

(t , T )
T

(2.21)

(2.22)

For a risk neutral world our conclusion Error: Reference source not found must hold whereby

r ( t ) is independent of T

and thus the last term of the forward rates drift vanishes. This has

as a consequence that the drift and diffusion of the forward rate are dependent of the forward rate
volatility

(t ,T ) . The model becomes:


T

dF ( t ,T )= ( t , T ) ( t , v ) dv dt+ ( t , T ) dX
t

(2.23)

For now we have described maturities as precise points in time, while in practice we describe
market values in terms of a fixed term. There for we introduce the Musiela parameterisation
where we switch from

to

T t= . We think about the forward rate volatility for a 20 yrs

maturity instead of the June 15th 2033 maturity.


In other words the forward rate for fixed term (notice the superscript) becomes:

( t , )=F ( t , t + )
F

(2.24)

Our forward rate volatility becomes:

( t , T )= ( t , T t )

(2.25)

The result we had with Error: Reference source not found now becomes with Musiela
parameterisation:

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[(

(2.26)

d F ( t , T ) = ( t , ) ( t , s ) ds + F ( t , ) dt+ ( t , ) dX

The extra term in the drift, can be explained while evolving the curve towards the next present
time (or observation time) we must respect the constant maturity and thus roll further on the
curve.

2.3 Multidimensional approach


In order to reflect the particularity of contracts with dependence on multiple points on the curve
we can better define the risk neutral forward rate curve with an N-dimensional SDE.

(2.27)

dF ( t ,T t )=m ( t , T t ) dt+ i ( t ,T t ) d X i
i=1

If we relate our HJM model to forward rate history we will have to determine the co-variances of
the observed maturity CHANGES in forward rates (dF) time-series. Notice this requires clean and
sufficiently populated data series. Once we have found this N*N covariance matrix

v i and eigenvalues

obtain the N eigenvectors

we will

who obey the matrix equation:

M v i=i v i

(2.28)

Wherein index i refers to the i-th maturity forward rate. For example i=3 could refer to the
instantaneous 1yr forward rate.
While the correlation matrix is symmetric and can be factorized as follows

M =V V

Here we have
transposed

(2.29)

a diagonal matrix with the eigenvalues on its main diagonal and

(and its

) are matrices of (column)eigenvectors

semi positive definite we can write this matrix as:

M =V1 /2 ( V 1/ 2)

(2.30)

Thus in a multi-dimensional setting we can rewrite our forward volatility factors as:

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(2.31)

( j )=( v i ) j i
Where

j is the j-th maturity and ( vi ) j is the j-the element of the i-th eigen(column)vector.

So the j-th element of the i-th eigenvector represents the movement of the j-th maturity. The i-th
eigen value represents the variance of the movement of th ith component.
It is interesting to analyse how the volatility functions influence the evolution of our forward curve.
Each eigenvalues corresponding eigenvector can be plotted by maturity, also described as
principal components. The plotted eigenvector belonging to the largest eigenvalue will usually be
a horizontal function. This reflects ones intuitive suspicion that most curve movements are rather
independent of maturity and represent a vertical shift of the existing curve. A second eigenvector
could represent some positive entries and for longer maturities negative entries which result in
tilting while positive movements on the short end would result in negative movements in the long
run and vice versa.
Maybe insert a graf representing eigenvector fct of maturity here
Our N-dimensional model becomes:

[(

d F ( t , T ) = ( t , ) ( t , s ) ds + F ( t , ) dt+ ( t , ) dX

d F ( t , T ) =

i (t , ) i (t , s ) ds + F ( t , )
i =1

dt + i ( t , ) d X i

(2.32)

(2.33)

i=1

Using our correlation matrix decomposition, we obtain a practical form for each j-indexed
maturity:

d F j ( t ,T )=

i ( v i ) j i ( v i) j ds+ F ( t , )
i=1

dt + i ( v i ) j d X i

(2.34)

i=1

2.4 Observing Parameters


For the multidimensional model we have assumed we obtained a correlation matrix from statistical
observation. This requires us to have sufficient time-series of the relevant T-maturity instantaneous
forward rates. The production of these can be a cumbersome work, though central banks do publish
them in more or less convenient formats.

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As when we do not necessarily want to mime reality based on past observations we can also impose
our own volatility structure

(t , ) . This can be handy to create stressed scenarios. The impact

of the principal components described above guide us to simulate the desired dynamics. So as if
one would not like the longer end of the curve to move one will choose accordingly smaller values
for the principal components on the longer end.

2.5 Volatility functions


2.6 Practical aspects of Monte Carlo
Simulation

2.6.1

Interpolation algorithm

In order to price instruments with precise maturities one will necessitate an interpolation algorithm
to apply on the simulated discrete forward rate curves.

2.6.2

Numerical integration

An algorithm must be provided to integrate the volatility structure in order to calculate the drift
factors.

2.6.3

Principal component analysis.

The determination of eigenvector and eigenvalues can be done efficiently by the iterative powerloop method. This orders eigenvalues automatically and also produces the eigenvectors.

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