Heath-Jarrow-Morton Model - What Is It, Formula, Assumptions

1/8/24, 11:50 AM Heath-Jarrow-Morton Model - What Is It, Formula, Assumptions
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Heath-Jarrow-Morton Model
Article by Edited by Reviewed by
Kumar Rahul Ashish Kumar Srivastav Dheeraj Vaidya, CFA, FRM
What Is Heath-Jarrow-Morton Model?

The Heath-Jarrow-Morton (HJM) model is a mathematical framework used
in mathematical finance to describe and analyze the structure of interest
rates. In addition, it provides a way to model and price interest rate
derivatives, such as bonds, swaps, and options.
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It is a no-arbitrage model that ensures no opportunities for risk-free profits in


the financial markets. The model assumes that the forward interest rates,
representing the interest rates for future periods, follow a particular stochastic
process. By specifying the dynamics of these forward rates, the model allows
for pricing interest rate derivatives.
Table of contents
What is Heath Jarrow Morton Model?

Heath Jarrow Morton’s Model Explained
Assumptions
Formula
Examples
Use
Frequently Asked Questions (FAQs)
Recommended Articles
Key Takeaways
The Heath-Jarrow-Morton model is a mathematical framework used

to model and analyze the term structure of interest rates. It
describes the dynamics of forward interest rates as a stochastic
process.
The model incorporates assumptions such as the absence of

arbitrage opportunities, continuous time, market completeness,
risk-neutral measure, and no preferences or market frictions.
The model is used for pricing and risk management of interest rate
derivatives, constructing yield curves, portfolio analysis, monetary
policy analysis, research, and financial modeling.


Heath-Jarrow-Morton Model Explained

The Heath-Jarrow-Morton (HJM) model is a significant advancement in
mathematical finance which is used to study the term structure of interest
rates. It revolutionized the analysis of the structure of interest rates. It was
introduced by researchers David Heath, Robert A. Jarrow, and Andrew Morton
in the early 1990s, building upon the earlier work of other researchers in the
field.
Unlike traditional models that use specific functional forms to describe the
term structure. The model focuses on the evolution of forward interest rates
over time. This feature allows for a more flexible and realistic representation of
interest rate movements. It considers the volatility and correlation of different
maturities.
Furthermore, the HJM model has contributed to a deeper understanding of

interest rate risk and its impact on financial markets. It has shed light on the
relationship between short-term and long-term interest rates, the behavior of
yield curves, and the effects of market expectations and macroeconomic
factors on interest rate movements. This knowledge has important implications
for monetary policy, fixed-income investing, and risk management in banks
and other financial institutions.
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Assumptions
The Heath-Jarrow-Morton (HJM) model is based on several key assumptions,
which include the following:
1. No-arbitrage: The model assumes the absence of arbitrage opportunities

in the financial markets. This means that it takes no risk-free profits can be
made by exploiting inconsistencies in prices or interest rates.
2. Continuous time: The model operates constantly, assuming that interest

rates and other relevant variables change smoothly over time. This
assumption allows using stochastic calculus and differential equations to
model interest rate dynamics.
3. Market completeness: The model assumes that the financial markets are
complete, meaning that all possible contingent claims can be perfectly
replicated by trading in the available securities. This assumption ensures a
special price for all derivative securities and that the model can accurately
price and hedge them.
4. Risk-neutral measure: The model employs a risk-neutral step, simplifying

derivative securities pricing. Under this measure, the expected return on
any security equals the risk-free rate. This assumption allows for using the
risk-neutral pricing framework and facilitates the valuation of interest rate
derivatives.
5. No restrictions on the volatility structure: The model does not impose

specific limits on the volatility structure of the forward interest rates. It
allows the volatility to be time-varying and stochastic, capturing the


observed volatility clustering and other dynamics in interest rate markets.
6. No preferences or market frictions: The model assumes that market

participants are risk-neutral and have no preferences regarding the
characteristics of the underlying interest rate process. It also takes the
absence of market frictions, such as transaction costs or liquidity
constraints, simplifying the analysis.
Formula
The Heath-Jarrow-Morton (HJM) model describes the dynamics of forward
interest rates, which are interest rates for future periods, as a stochastic
process.
In its simplest form, the model can be represented by the following equation:
df (t, T) = α (t, T)dt + σ (t, T) dW (t),
Where:
df (t, T) represents the instantaneous change in the forward rate from

time t to time T.
α (t, T) is the drift term, representing the expected forward rate change.
σ (t, T) is the volatility term, which captures the randomness and

fluctuations in the forward rate.
dt represents an infinitesimally small time increment.
dW (t) is a Wiener process or Brownian motion, meaning the model’s

random noise.
The drift term α (t, T) and the volatility term σ (t, T) can be functions of time t
and maturity T, determining the behavior and characteristics of the forward
rates. These functions can be calibrated to historical market data or estimated


using other models or statistical techniques.
The model provides a system of partial differential equations (PDEs) that must
be solved to determine the forward rates at different maturities. These PDEs are
derived by applying Itô’s lemma and the no-arbitrage condition.
The specific form of the drift and volatility functions α (t, T) and σ (t, T) can vary
depending on the model’s version or extensions. More complex versions of the
HJM model may incorporate additional factors, such as stochastic volatility or
mean-reversion, to better capture market dynamics.
Examples
Let us understand it with the help of examples:
Example #1
Let’s consider an imaginary example within the framework of the Heath-Jarrow-

Morton (HJM) model. Suppose we have a simplified term structure consisting
of three different maturities: 1 year, 2 years, and 3 years.
Assuming the following drift and volatility functions for the forward rates:
α (t, T) = 0.05 – 0.02 * T,
σ (t, T) = 0.015 + 0.01 * T,
Where t represents the current time, and T represents the time to maturity.
Let’s say the current time is t = 0, and we want to simulate the forward rates at
different maturities.
For example, let’s assume a discrete time step of 0.25 years.
Starting with initial forward rates at t = 0:

The forward rate at 1 year: f (0, 1) = 0.04


The forward rate at 2 years: f (0, 2) = 0.042
The forward momentum at 3 years: f (0, 3) = 0.044
We can simulate the forward rates at subsequent time steps using the drift
and volatility functions. Here’s a simplified example of the simulation for three-
time actions:
Simulation
#1 – At t = 0.25 years:
Forward rate at 1 year: f (0.25, 1) = f(0, 1) + α(0, 1) * dt + σ(0, 1) * dW(0.25)
Forward rate at 2 years: f (0.25, 2) = f(0, 2) + α(0, 2) * dt + σ(0, 2) *

dW(0.25)
Forward rate at 3 years: f (0.25, 3) = f(0, 3) + α(0, 3) * dt + σ(0, 3) *

dW(0.25)
#2 – At t = 0.5 years:
Forward rate at 1 year: f (0.5, 1) = f(0.25, 1) + α(0.25, 1) * dt + σ(0.25, 1) *

dW(0.5)
Forward rate at 2 years: f (0.5, 2) = f(0.25, 2) + α(0.25, 2) * dt + σ(0.25, 2) *

dW(0.5)

dW(0.5)
#3 – At t = 0.75 years:
Forward rate at 1 year: f (0.75, 1) = f(0.5, 1) + α(0.5, 1) * dt + σ(0.5, 1) *

dW(0.75)


dW(0.75)

dW(0.75)
In conclusion, the specific values of dW(0.25), dW(0.5), and dW(0.75) represent

the unexpected shocks or increments at each time step.
Example #2
One real-life example of the Heath-Jarrow-Morton (HJM) model can be seen in

its application in the pricing and risk management of mortgage-backed
securities (MBS) during the subprime mortgage crisis of 2008.
The subprime mortgage crisis was a significant financial event that resulted in a
sharp decline in the value of mortgage-backed securities and had widespread
implications for the global financial system. During this crisis, the model played
a crucial role in assessing the risks associated with these complex financial
instruments.
Mortgage-backed securities are financial instruments created by pooling a

group of mortgages and issuing securities backed by cash flows. The value of
these securities is highly dependent on the interest rates and prepayment
behavior of the underlying mortgages.
With its ability to capture the dynamics of the structure of interest rates, the
model provided a valuable tool for pricing and risk management of mortgage-
backed securities during the crisis. Thus, it allowed market participants to
model the expected cash flows and price these securities based on the
dynamics of interest rates.
The crisis highlighted the challenges of accurately valuing and hedging

mortgage-backed securities, mainly when interest rates and mortgage
prepayment behavior deviated from historical norms.


Uses
The HJM model has proven to be highly relevant and influential in various
areas of finance. Some of its key uses include:
1. Pricing Interest Rate Derivatives: The model prices various interest rate
derivatives, including interest rate swaps, caps, floors, and swaptions,
and exotic products. By incorporating the dynamics of the term structure
of interest rates, the model provides a framework for valuing these
complex financial instruments and determining fair prices.
2. Risk Management: The model plays a crucial role in risk management for
financial institutions, especially those exposed to interest rate risk. It allows
for calculating risk measures such as value-at-risk (VaR) and expected
shortfall, enabling institutions to assess and manage the potential losses
associated with interest rate movements and derivative positions.
3. Yield Curve Construction: The model aids in constructing yield curves,

which are essential for pricing and valuation purposes. Thus, by
incorporating market data and fitting the model’s parameters, the model
helps create yield curves that accurately reflect the term structure of
interest rates and facilitate decision-making for fixed-income investments.
4. Portfolio Analysis: The model analyzes and evaluates interest rate

portfolios. In addition, it enables financial institutions to assess the risk and
performance of their portfolios by incorporating the expected behavior of
forward rates, volatility, and correlations among different maturities.
5. Monetary Policy Analysis: Central banks and policymakers use it to

assess the impact of their monetary policy decisions on the economy and
financial markets. By simulating the forward rates and yield curves under
different policy scenarios, policymakers can evaluate the potential
consequences of interest rate changes and inform their decision-making


process.
Frequently Asked Questions (FAQs)

1. What is the difference between the Heath-Jarrow-Morton (HJM) model
and other interest rate models?
The forward-rate-based model describes the entire term structure of interest
rates as a system of stochastic differential equations. In contrast, other models
like the Vasicek or Cox-Ingersoll-Ross (CIR) model focus on modeling short-
term interest rates or specific aspects of the yield curve.
2. How is the Heath-Jarrow-Morton (HJM) model calibrated to market

data?
Calibrating the model involves determining the parameters of the model that
best-fit market data, typically yield curve or bond prices. This process often
involves numerical optimization techniques to minimize the difference between
the model’s predicted and observed market prices.
3. Can the Heath-Jarrow-Morton (HJM) model capture negative interest

rates?
Yes, the model can capture negative interest rates. It allows for negative
forward rates by incorporating the dynamics of the structure of interest rates,
including the drift and volatility functions, which can account for adverse rate
environments.
Recommended Articles
This has been a guide to what is Heath-Jarrow-Morton Model. Here, we explain
the topic with its assumptions, formula, examples, and uses. You can learn more
about it from the following articles –
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1/8/24, 11:50 AM Heath-Jarrow-Morton Model - What Is It, Formula, Assumptions

Home » Fixed Income Resources » Heath-Jarrow-Morton Model

What Is Heath-Jarrow-Morton Model?

It is a no-arbitrage model that ensures no opportunities for risk-free profits in

What is Heath Jarrow Morton Model?

Frequently Asked Questions (FAQs)

The Heath-Jarrow-Morton model is a mathematical framework used

The model incorporates assumptions such as the absence of

policy analysis, research, and financial modeling.

Heath-Jarrow-Morton Model Explained

Furthermore, the HJM model has contributed to a deeper understanding of

Financial Modeling & Valuation Courses Bundle (25+ Hours Video

–>> If you want to learn Financial Modeling & Valuation professionally ,

comprehensive course covering McDonald’s forecast methodologies,

Start Learning Now

1. No-arbitrage: The model assumes the absence of arbitrage opportunities

2. Continuous time: The model operates constantly, assuming that interest

4. Risk-neutral measure: The model employs a risk-neutral step, simplifying

5. No restrictions on the volatility structure: The model does not impose

allows the volatility to be time-varying and stochastic, capturing the

6. No preferences or market frictions: The model assumes that market

df (t, T) = α (t, T)dt + σ (t, T) dW (t),

df (t, T) represents the instantaneous change in the forward rate from

σ (t, T) is the volatility term, which captures the randomness and

dt represents an infinitesimally small time increment.

dW (t) is a Wiener process or Brownian motion, meaning the model’s

rates. These functions can be calibrated to historical market data or estimated

Let’s consider an imaginary example within the framework of the Heath-Jarrow-

α (t, T) = 0.05 – 0.02 * T,

σ (t, T) = 0.015 + 0.01 * T,

For example, let’s assume a discrete time step of 0.25 years.

Starting with initial forward rates at t = 0:

The forward rate at 1 year: f (0, 1) = 0.04

The forward momentum at 3 years: f (0, 3) = 0.044

Forward rate at 1 year: f (0.25, 1) = f(0, 1) + α(0, 1) * dt + σ(0, 1) * dW(0.25)

Forward rate at 2 years: f (0.25, 2) = f(0, 2) + α(0, 2) * dt + σ(0, 2) *

Forward rate at 3 years: f (0.25, 3) = f(0, 3) + α(0, 3) * dt + σ(0, 3) *

Forward rate at 1 year: f (0.5, 1) = f(0.25, 1) + α(0.25, 1) * dt + σ(0.25, 1) *

Forward rate at 2 years: f (0.5, 2) = f(0.25, 2) + α(0.25, 2) * dt + σ(0.25, 2) *

Forward rate at 3 years: f (0.5, 3) = f(0.25, 3) + α(0.25, 3) * dt + σ(0.25, 3) *

Forward rate at 1 year: f (0.75, 1) = f(0.5, 1) + α(0.5, 1) * dt + σ(0.5, 1) *

Forward rate at 2 years: f (0.75, 2) = f(0.5, 2) + α(0.5, 2) * dt + σ(0.5, 2) *

Forward rate at 3 years: f (0.75, 3) = f(0.5, 3) + α(0.5, 3) * dt + σ(0.5, 3) *

In conclusion, the specific values of dW(0.25), dW(0.5), and dW(0.75) represent

One real-life example of the Heath-Jarrow-Morton (HJM) model can be seen in

Mortgage-backed securities are financial instruments created by pooling a

The crisis highlighted the challenges of accurately valuing and hedging

prepayment behavior deviated from historical norms.

3. Yield Curve Construction: The model aids in constructing yield curves,

4. Portfolio Analysis: The model analyzes and evaluates interest rate

5. Monetary Policy Analysis: Central banks and policymakers use it to

consequences of interest rate changes and inform their decision-making

Frequently Asked Questions (FAQs)

2. How is the Heath-Jarrow-Morton (HJM) model calibrated to market

3. Can the Heath-Jarrow-Morton (HJM) model capture negative interest

Fixed Income Funds

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