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

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  • Leonard Tchuindjo

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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  • Leonard Tchuindjo, 2008. "Factors' correlation in the Heath–Jarrow–Morton interest rate model," Applied Stochastic Models in Business and Industry, John Wiley & Sons, vol. 24(4), pages 359-368, July.
    • Handle: RePEc:wly:apsmbi:v:24:y:2008:i:4:p:359-368
    DOI: 10.1002/asmb.718
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