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2
, (2.1)
where is the drift of y(t) under the P
1
-measure. For 0 < T < T
1
the implied
risk-neutral measure P
is given by
dP
dP
1
F
T
= exp
_
_
T
0
1
dw
1
s
_
T
0
1/2|
1
|
2
ds
_
. (2.2)
Proof. The short rate is a function of y(t), r(t) = r(t, y(t)). By
numeraire invariance we require
p(t, T) = B
1
(t)E
1
[1/B
1
(T)|F
t
] = e
y(t)(T
1
t)
E
1
_
e
y(T)(T
1
T)
F
t
_
= E
_
e
T
t
r(s)ds
F
t
_
,
(2.3)
where P
2
)
F
y
+ 1/2
2
F
y
2
2
_
dt +
1
B
1
(t)
F
y
dw
1
(t)
+F
1
B
1
(t)
_
y(t) +
1
+ 1/2
2
1
dt +F
1
B
1
(t)
1
dw
1
(t).
That is
d(e
y(t)(T
1
t)
p(t, T)) = (
A
t
F (y(t)
1
1/2
2
1
2
)F)dt + (...)dw
1
, (2.4)
where
A
t
=
t
+ ( +
1
2
)
y
F + 1/2
2
2
yy
F. This identies simultaneously the
short rate as r(t) = y(t)
1
1/2
2
1
2
and the risk-neutral measure given by
(2.2). The market prices of risk are
1
, that is the volatility of the B
1
(t) over
the period [0, T
1
).
In fact Eq. (2.3) denes an arbitrage free value for p(t, T) for t T T
1
. For
example assuming a Gaussian process for y(t) we obtain the following
Proposition 2.2. Assume we are given positive constants a, b, and a Brownian
motion w(t) under the P
1
forward-measure. Dene y(t) as the strong solution to
dy(t) = (a by(t))dt +dw
t
.
Then the arbitrage-free price of a zero-coupon bond maturing at T T
1
is given by
p(t, T) = exp(n(t, T) m(t, T)y(t)), (2.5)
with
m(t, T) = (T
1
t) (T
1
T)e
b(Tt)
,
n(t, T) = (T
1
T)
a
b
_
1 e
b(Tt)
_
+
(T
1
T)
2
2
4b
(1 e
2b(Tt)
).
Proof. By standard results the distribution of y(T)(T
1
T) given y(t) with t < T
is N((T
1
T)k, (T
1
T)
2
s
2
) with
k = y(t) exp(b(T t)) +
a
b
(1 exp(b(T t))),
s
2
=
2
2b
(1 exp(2b(T t))).
6 M. Davis & V. Mataix-Pastor
With these assumptions Eq. (2.3) gives us
p(t, T) = e
y(t)(T
1
t)
E
1
_
e
y(T)(T
1
T)
F
t
_
= e
y(t)(T
1
t)
e
(T
1
T)k+(T
1
T)
2
s
2
/2
,
giving Eq.(2.5).
In the next section we show that given a model specied under the forward
measure there exists a unique short rate independent of maturity which corresponds
to a nite variation process representing a savings account. We use results from
Bjork [2].
2.1. Self-nancing trading strategies and zero-coupon bond pricing
Equation (2.3) denes an arbitrage free term structure for T < T
1
which depends
on the drift and volatility of the yield y(t). We dont need to assume any function
for the short rate. In what follows we repeat the steps in Bjorks description of
short rate models (Section 21.2 in [2]) to nd an alternative derivation of the term
structure PDE in terms of self-nancing trading strategies using the p(t, T) and
B
1
(t) as traded assets which will also allow us to obtain the hedging parameters.
Letting p(t, T) = F(t, y(t)) and applying Ito to F and B
1
(t) = exp(y(t)(T
1
t))
we have
dp(t, T) = (F
t
+F
y
+ 1/2
2
F
yy
)dt +F
y
dw
1
, (2.6)
dB
1
(t)/B
1
(t) = (y(t)
1
+ 1/2
2
1
2
)dt
1
dw
1
. (2.7)
Denote the drift and diusion of p by m
T
= F
t
+ F
y
+ 1/2
2
F
yy
and b
T
= F
y
,
and similarly denote the drift and volatility of B
1
(t) by m
1
and b
1
respectively.
Assume we are interested in pricing a zero-coupon bond with maturity T < T
1
.
We form a portfolio based on T and T
1
bonds. Let u
T
(t) and u
1
(t) denote the
proportions of total value held in bonds p(t, T) and B
1
(t) respectively, held in a
self-nancing portfolio at time t. The dynamics of the portfolio are given by
dV = V
_
u
T
(t)
dp(t, T)
p(t, T)
+u
1
(t)
dB
1
(t)
B
1
(t)
_
. (2.8)
Substitute (2.6) and (2.7) into (2.8) to obtain
dV = V (u
T
m
T
+u
1
m
1
)dt +V (u
T
b
T
+u
1
b
1
)dw
1
. (2.9)
Let the portfolio weights solve the system
u
T
+u
1
= 1, (2.10)
u
T
b
T
+u
1
b
1
= 0.
Arbitrage-free interpolation of the swap curve 7
The rst equation is the self-nancing property and the second makes the dw
1
-term
in (2.8) vanish. The value of the SFTS (u
T
, u
1
) is the solution to (2.10) and is given
by
u
T
=
b
1
b
T
b
1
, u
1
=
b
T
b
T
b
1
.
Substitute the solution into (2.9) to obtain
dV = V
_
m
1
b
T
m
T
b
1
b
T
b
1
_
dt.
Absence of arbitrage requires to set the drift above equal to the spot rate r. That
is
m
1
b
T
m
T
b
1
b
T
b
1
= r,
which can be rewritten as
m
T
r
b
T
=
m
1
r
b
1
. (2.11)
The ratio above is independent of the bond and is usually known as the market
prices of risk. Since the risk comes from the randomness in B
1
(t) we set the above
ratio equal to its volatility b
1
=
1
. Substituting this on the right hand side of
(2.11) we obtain
r(t) = y(t) (T
i+1
t) 1/2(T
i+1
t)
2
2
,
so (2.11) becomes
m
T
r
b
T
= b
1
. (2.12)
Equation (2.12) is in fact another way of writing the PDE appearing in the proof of
Proposition 2.1 which in the usual short rate models corresponds to the well known
Vasicek PDE.
From this discussion we will show next that if p(t, T) is given by linear interpo-
lation of the yields, the implied short rate depends on the maturity date T and so
we can create an arbitrage opportunity.
2.2. Arbitrage opportunities in a linear interpolation
We now illustrate how to compute an arbitrage opportunity in a bond market
where bonds are obtained by log-linear interpolation from a set of benchmark rates.
Consider again the small market introduced in the beginning of the section. Let
t < T
1
and T [T
1
, T
2
] where T
1
< T
2
and let = T t and
2
= T
2
t. We are
given a system under the T
2
bond forward measure P
2
dy
1
=
1,2
dt +
1
dw
2
,
dy
2
=
2
dt +
2
dw
2
,
8 M. Davis & V. Mataix-Pastor
where
1,2
= (y
1
y
2
+
2
2
+ 1/2)/
1
,
=
1
1
+
2
2
2
1
2
,
so that p(t, T
1
)/p(t, T
2
) is a P
2
-martingale. Dene the interpolated yield for a bond
maturing at time T by
y(t, T) = (T)y
1
(t) + (1 (T))y
2
(t),
where
(T) =
T
2
T
T
2
T
1
.
From Ito it follows that
dy(t, T) =
y
dt +
y
dw
2
(t),
where the drift
y
and volatility
y
are given by
y
= (T)
1,2
+ (1 (T))
2
,
y
= (T)
1
+ (1 (T))
2
.
The new bond price is
p(t, T) = exp(y(t, T)(T t)).
Equations (2.6) and (2.7) now read as
dp(t, T) = (y(t, T)
y
+ 1/2(
y
)
2
)dt
y
dw
2
(t),
dp(t, T
2
) = (y
2
(t)
2
2
+ 1/2(
2
2
)
2
)dt
2
2
dw
2
(t),
and we can construct a nite variation process like (2.9). Choose proportions of
wealth V
t
in bonds B
1
(t) and p(t, T) be
u
T
=
2
y
2
2
, u
1
=
y
y
2
2
. (2.13)
Hence the system in (2.9) is
dV
t
V
t
=
m
2
y
+m
T
dt.
Letting the spot rate r(t) be
r(t) =
m
2
y
+m
T
= y
2
+
(T)
2
(
1
1,2
) +
2
2
(y
1
y
2
) +
2
2
(y
1
y
2
)
,
this depends on the maturity T. Denote by (t, T) and (t, T
1
) the number of units
of bonds with maturity T and T
1
respectively. They are related from the bond
Arbitrage-free interpolation of the swap curve 9
portfolios by u(t, T) = (t, T)V
T
/P(t, T) and u(t, T
1
) = (t, T
1
)V
T
/P(t, T
1
). Hence
from (2.13) these trading strategies are
(t, T) =
T t
T
1
T
V (0) exp(
_
t
0
r(s)ds)
p(t, T)
,
(t, T
1
) =
t T
T T
1
V (0) exp(
_
t
0
r(s)ds)
p(t, T
1
)
.
Since the implied spot rate is a smooth function of T we can nd maturities T
and
T
) < r(t, T
, T
) to
obtain a prot.
3. Interpolation of swap market models
The data used to construct the zero curve usually from two years onwards consists
of swap rates. We now give a brief outline of the swap market model and introduce
some notation following Jamshidian [17].
3.1. Co-terminal swap market model
We are given a tenor structure 0 < T
1
< ... < T
n
with accrual factors R
n
+
,
i
= T
i+1
T
i
, so that
i
is the time interval T
i+1
T
i
expressed according to some
day-count convention. For t T
i
denote by B
i
(t) the price of a zero coupon bond
at time t with maturity date T
i
and S
i
(t) the forward swap rate starting at date T
i
and with reset dates T
j
for j = i, ..., n 1. Forward swap rates are related to zero
coupon bonds by
S
i
(t) =
B
i
(t) B
n
(t)
A
i
(t)
, 0 t T
i
, (3.1)
where A
i
(t)
n
j=i+1
j1
B
j
(t), the annuity. We want to obtain prices of zero-
coupon bonds from these rates. Towards that aim one can show algebraically from
(3.1) and using induction that if we let
v
ij
v
ij,n
n1
k=j
k
k
l=i+1
(1 +
l1
S
l
), (3.2)
v
i
v
ii
, 1 i j n 1, (3.3)
we can then express the ratios B
i
/B
n
(see [17]) for 0 t T
i
, i = 1, ..., n 1 as
A
i
(t)
B
n
(t)
= v
i
(t), (3.4)
B
i
(t)
B
n
(t)
= (1 +v
i
(t)S
i
(t)). (3.5)
10 M. Davis & V. Mataix-Pastor
We want to be able to interpret B
i
(t) as the price of a zero-coupon bond maturing
at time T
i
, so by setting B
i
(T
i
) = 1 we can deduce from (3.5), for i = 1, ..., n 1
B
n
(T
i
) = 1/(1 +v
i
(T
i
)S
i
(T
i
)). (3.6)
We dene the auxiliary process Y
i
(t)
Y
i
(t) :=
B
i
(t)
B
n
(t)
= (1 +v
i
(t)S
i
(t)). (3.7)
These Y
i
process will be martingales under the P
n
forward measure. From (3.5) we
have that Y
i
/Y
i+1
= 1 +
i
L
i
where L
i
(t) denotes the forward Libor rate set at T
i
and paying at T
i+1
and we obtain the relation between Libor and swap rates
1 +
i
L
i
(t) =
1 +v
i
(t)S
i
(t)
1 +v
i+1
(t)S
i+1
(t)
. (3.8)
Notice that a model on the forward swap rates can generate a negative Libor rate
L
k
(t) for some k = 1, ..., n 1 if it happens that
S
k
(t) <
v
k+1
(t)S
k+1
(t)
v
k
(t)
. (3.9)
See for example [8] and [18] for a more detailed discussion.
The swap market model is described by the following: a set of forward swap
rates S
i
(0) for i = 1, ..., n 1, an n 1 dimensional vector of bounded, measur-
able, locally Lipschitz functions
i
(t, S(t)) R
d
. The swap rate follows a positive
martingale under the corresponding annuity measure, that is the measure cor-
responding to using the annuity A
i
(t) as the numeraire. More precisely, given a
ltered probability space (, F
t
, P
in
) supporting a d-dimensional Brownian motion
w
in
, the swap rate S
i
(t) is given by the strong solution to
dS
i
(t) = S
i
(t)
i
(t, S(t))dw
in
(t).
In particular P
n1,n
= P
n
, the terminal measure. The Radon-Nikodym derivative
for the change of measure to the P
n
-forward measure is given by
dP
n
dP
in
=
A
i
(0)
B
n
(0)
B
n
(T
i
)
A
i
(T
i
)
=
v
i
(0)
v
i
(T
i
)
. (3.10)
One can use backward induction to deduce the form of the drift term for all swap
rates under the P
n
measure. We recall from Jamshidian [17].
Proposition 3.1. (Jamshidian) If we are given a ltered probability space
(, F
t
, P
n
), supporting a Brownian motion w
n
R
d
, and data consisting of an n1
dimensional vector of bounded, measurable, locally Lipschitz functions
i
(t, S) R
d
and initial forward swap rates S
i
(0) for i = 0, ..., n 1, then the SDE
dS
i
= S
i
i
n1
j=i+1
j1
S
j
t
j
(1 +
j1
S
j
)
v
ij
v
i
dt +S
i
i
dw
n
, (3.11)
Arbitrage-free interpolation of the swap curve 11
has a strong solution and v
i
and S
i
v
i
are P
n
-martingales for all i where v
i
is dened
by (4.6).
Similarly we can derive the SDE for S
i
(t) taking any other annuity A
k
as the
numeraire for any k = 1, ..., i 1, i +1, ...n1. Similarly to (3.10) we can dene the
forward measure P
kn
by dP
kn
/dP
in
= cv
k
/v
i
where c = v
in
(0)/v
kn
(0). The process
for t T
i
, S
i
(t) is then given under the P
kn
measure by
dS
i
(t)
S
i
(t)
=
i
(t)
_
_
n1
l=k+1
l1
S
l
(t)
l
(t)
1 +
l1
S
l
(t)
v
kl
(t)
v
k
(t)
n1
j=i+1
j1
S
j
(t)
j
(t)
1 +
j1
S
j
(t)
v
ij
(t)
v
i
(t)
_
_
dt+
i
(t)dw
kn
.
(3.12)
Notice that by setting l = n 1 we recover (3.11). We will make use of these
dynamics in Section 4.
It seems natural to nd an arbitrage-free interpolation of the yield curve by
extending the swap market model.
3.2. Interpolation
We want to price zero-coupon bonds given a numeraire asset with price process
N(t) by applying (1.1) which we rewrite below,
p(t, T) = N(t)E
i
[1/N(T)|F
t
].
The problem with market models is that it doesnt give us continuous time dynamics
for any bond in the tenor structure. Recall that given a Libor or a swap market
model we can obtain the process for any ratio of zero coupon bonds by dening the
auxiliary process Y
j
i
(t) with i < j, by
Y
j
i
(t)
j1
m=i
(1 +
m
L
m
(t)) =
B
i
(t)
B
j
(t)
, (3.13)
in the LMM and
Y
j
i
(t)
1 +v
i
(t)S
i
(t)
1 +v
j
(t)S
j
(t)
=
B
i
(t)
B
j
(t)
, (3.14)
in the SMM for j < n and Y
n
i
(t) = 1 + v
i
(t)S
i
(t). Furthermore from Proposition
3.1 the process Y
j
i
(t) follows a P
j
-martingale. We want to interpret B
i
as the zero-
coupon bond maturing at time T
i
, that is we need B
i
(T
i
) = 1. We thus require
B
i
(T
i
)/B
j
(T
i
) = 1/B
j
(T
i
) for i < j and, since B
i
(T
i
)/B
j
(T
i
) = Y
j
i
(T
i
) we can
dene the random variables B
j
(T
i
) uniquely by
B
j
(T
i
) =
1
Y
j
i
(T
i
)
. (3.15)
Summarizing, a market model provides us with the continuous time process of any
ratio of zero coupon bonds as in (3.13) and (3.14) but we only have the prices of
each individual bond at a nite number of dates as equation (3.15) shows.
12 M. Davis & V. Mataix-Pastor
To apply (1.1) for pricing zero coupon bonds we need the continuous time
dynamics of a numeraire , say B
n
(t), so we need to extend the denition of B
n
(.)
given in (3.15) with j = n to times t (T
i
, T
i+1
) for i = 1, ..., n1 by interpolating
the random variables in (3.15) and setting B
n
(T
n
) = 1. Note that in this context
we mean interpolation with respect to present date, that is in the t parameter, and
not with respect to maturity, that is in the T parameter.
This is equivalent to dening short bonds as Schlogl [24] suggests, that is
arbitrarily dening B
i
(t) for all i = 1, ..., n where t (T
i1
, T
i
) but letting
B
i
(T
i1
) = (1 +
i1
L
i1
(T
i1
))
1
and B
i
(T
i
) = 1.
These approaches are equivalent because having dened B
n
(t) for t [0, T
n
],
it automatically denes processes for bonds B
i
(t) for 0 t T
i
and T
i
T since
from, say (3.14), we can set
B
i
(t) = Y
i
(t)B
n
(t). (3.16)
Alternatively having all short bonds we can obtain B
n
(t) for all t. Say for example
t [T
i
, T
i+1
], then we take the previously dened bond B
i+1
(t) and let
B
n
(t) = B
i+1
(t)/Y
i+1
(t).
Schlogl proposes two interpolations for Libor market models. The rst one is
a linear interpolation which produces a piecewise deterministic short rate for t
[T
i
, T
i+1
)
B
i+1
(t) =
1
1 +(t)L
i
(T
i
)
,
where
(t) =
T
i+1
t
T
i+1
T
i
,
and a second interpolation which introduces volatility in the short rate. It exploits
the fact that any Libor rate, say L
i
, has a known transition probability distribu-
tion under two forward measures P
i
and P
i+1
corresponding to using B
i
and B
i+1
as numeraires respectively. The linear interpolation will be extended to the swap
market model. However the second interpolation proposed in [24] used to introduce
volatility in the short rate can not be extended to the swap market model. There-
fore we propose an additional method which works well for the swap market model
and also ts in with the Libor market model. In addition since only martingale
properties will be used the method also works for Levy market models.
We use the fact that the data for the short end of the curve consists of yields to
suggest the following interpolation process for B
n
(t)
B
n
(t) =
1
e
y(t)(T
k+1
t)
Y
k+1
(t)
, t [T
k
, T
k+1
], (3.17)
where y(t) is the strong solution of some SDE driven by a Brownian motion under
the P
k+1
-forward measure
dy(t) =
k+1
(y(t))dt +(y(t))dw
k+1
,
Arbitrage-free interpolation of the swap curve 13
with initial condition
y(T
k
) =
ln(1 +
k
L
k
(T
k
))
T
k+1
T
k
, for k = 0, ..., n 1.
The boundary conditions B
n
(T
k
) = 1/Y
k
(T
k
) and B
n
(T
n
) = 1 are indeed satised
since we have
e
y(T
k
)(T
k+1
T
k
)
= 1 +
k
L
k
(T
k
) =
1 +v
k
(t)S
k
(t)
1 +v
k+1
(t)S
k+1
(t)
. (3.18)
The interpolation in (3.17) is equivalent to interpolating the short bonds since
applying (3.16) with i = k + 1
B
k+1
(t) = Y
k+1
(t)B
n
(t) = e
y(t)(T
k+1
t)
for t [T
k
, T
k+1
].
The process y(t) is dened for t [0, T
n
] but the idea is to interpret it as a
short term yield, hence we can use the volatility of the yields at the short end of the
curve to specify the volatility which remains unchanged for all t. Unfortunately
the drift depends on the section of the tenor structure where the process lies, so for
t [T
k
, T
k+1
) the process is evolved under the P
k+1
measure and is not specied at
this point.
We can use the results from the second section to dene a short rate for t
[T
k
, T
k+1
) by
r(t) = y(t) (T
k+1
t)
k+1
1/2(T
k+1
t)
2
2
.
This implied short rate however is discontinuous. At t = T
k
r(T
k
) = y(T
k
),
and at t = T
k
r(T
k
) = y(T
k
) (T
k+1
T
k
)
k+1
1/2(T
k+1
T
k
)
2
2
,
where y(T
k
) =
1
T
k+1
T
k
ln(1 +
k
L
k
(T
k
)). Hence
r(T
k
) = (y
k
y
k
)
k+1
k+1
1/2
2
k+1
2
.
We have the ability to freely choose the drift for the y(t) process which allows us
to rule out discontinuities in the short rate. For example we could choose a process
for y(t) with t [T
k
, T
k+1
) such as
dy(t) = (a
k
+(y(t)))dt +(y(t))dw
k+1
(t),
where a
k
is a F
T
k
measurable random variable that satises
a
k
=
(y
k
y
k
)
k
1
2
2
(y
k
)
k
(y
k
),
and SDE becomes
dy(t) =
_
1
k
(y
k
y
k
)
1
2
2
(y
k
)
_
dt +(y(t))dw
k+1
(t).
14 M. Davis & V. Mataix-Pastor
However from looking at the expectation denition above and the reset condition
at each T
k
this assumption would complicate the calculations such as the ones in
Section 2.1.
We extend the self-nancing strategies found in Section 2.1 to bonds with ma-
turity T [T
i
, T
i+1
). Denote by
j
the number of bonds B
j
held in the portfolio
and let it be
j
(t) = I
[T
j
,T
j+1
)
(t) , j = 1, ..., i, (3.19)
T
(t) =
u
T
V (t)
p(t, T)
, for t [T
i
, T], (3.20)
i+1
=
u
i+1
V (t)
B
i+1
(t)
, (3.21)
with (u
T
, u
i+1
) as in (2.10) with i+1 instead of 1. We call the implied numeraire cor-
responding to this SFTS the rolling horizon numeraire and its martingale measure
is denoted by P
SL
since this corresponds to the Spot Libor measure in Jamshidian
[17]. Note that it will be used for swap market models as well.
For T [T
i
, T
i+1
) the price of a zero-coupon bond p(t, T) using this rolling
horizon numeraire is given in the following proposition
Proposition 3.2. Dene q
j1
= e
y
T
j1
(T
j
T
j1
)
= B
j
(T
j1
) for j = 1, ..., n.
Then for k < i, t [T
k
, T
k+1
] and T [T
i
, T
i+1
), then price of a zero-coupon bond
p(t, T) under P
SL
is given by
p(t, T) = B
i+1
(t)E
SL
[1/B
i+1
(T)]
= B
k
(t)E
k+1
_
q
k+1
E
k+2
_
q
k+2
E
i
_
q
i
E
i+1
_
1/B
i+1
(T)| F
T
i
)| F
T
i1
_
F
T
k+1
_
F
t
_
,
(3.22)
and for k = i
p(t, T) = B
i+1
(t)E
i+1
[1/B
i+1
(T)|F
t
].
Proof. The second equality in (3.22) follows from the constructions of the rolling
horizon numeraire and P
SL
given in equations (3.19) to (3.21). Now p(s, T)/B
i+1
(s)
is a P
i+1
-martingale for s [T
i
, T
i+1
], so by denition
p(T
i
, T) = B
i+1
(T
i
)E
i+1
_
1
B
i+1
(T)
F
T
i
_
.
Now p(s, T)/B
i
(s) is a P
i
-martingale for s [T
i1
, T
i
], hence substituting the above
Arbitrage-free interpolation of the swap curve 15
expression in the expectation formula
p(T
i1
, T) = B
i
(T
i1
)E
i
_
p(T
i
, T)| F
T
i1
= B
i
(T
i1
)E
i
_
B
i+1
(T
i
)E
i+1
_
1
B
i+1
(T)
F
T
i
_
F
T
i1
_
= B
i
(T
i1
)E
i
_
B
i+1
(T
i
)E
i+1
_
e
y(t)(T
i+1
T)
F
T
i
_
F
T
i1
_
= q
i
E
i
_
q
i+1
E
i+1
_
e
y(t)(T
i+1
T)
F
T
i
_
F
T
i1
_
.
The result follows by backward iteration.
3.3. Examples
In this section we give three explicit formulas for zero-coupon bonds of arbitrary
maturity. The rst one rewrites the linear interpolation as in Schlogl [24] in the
context of the SMM and shows that the implied spot rate has zero volatility between
tenor dates. The next two uses a stochastic process for y(t).
3.4. Linear interpolation
We apply the linear interpolation carried out by Schlogl in [24] to the swap market
model to obtain closed form solutions to zero-coupon bond prices. Dene B
n
(t) as
follows: for t [T
i
, T
i+1
),
B
n
(t) =
1
(1 +(t)(y(T
i
) 1))(1 +v
i+1
(t)S
i+1
(t))
,
where
(t) =
T
i+1
t
T
i+1
T
i
, and y(T
i
) =
1 +v
i
(T
i
)S
i
(T
i
)
1 +v
i+1
(T
i
)S
i+1
(T
i
)
.
With this denition one can check that indeed we meet the boundary conditions
B
n
(T
j
) = (1 +v
j
(T
j
)S
j
(T
j
))
1
for j = i, i + 1 as required by relation (3.15).
We have the following result.
Proposition 3.3. With the above denition of B
n
(t) we have, for any T
k
t <
T
k+1
T
i
T T
i+1
,
p(t, T) =
1 +v
i+1
(t)S
i+1
(t) +(T)(v
i
(t)S
i
(t) v
i+1
(t)S
i+1
(t))
(1 +(t)(y(T
k
) 1))(1 +v
k+1
(t)S
k+1
(t))
. (3.23)
16 M. Davis & V. Mataix-Pastor
Proof.
p(t, T)
B
n
(t)
= E
n
t
[B
n
(T)
1
]
= E
n
t
[(1 +(T)(y(T
i
) 1))(1 +v
i+1
(T)S
i+1
(T))]
= E
n
t
[1 +(T)E
n
T
i
[(y(T
i
) 1)(1 +v
i+1
(T)S
i+1
(T))]
= E
n
t
[1 +v
i+1
(T
i
)S
i+1
(T
i
) +(T)(v
i
(T
i
)S
i
(T
i
) v
i+1
(T
i
)S
i+1
(T
i
))]
= 1 +v
i+1
(t)S
i+1
(t) +(T)(v
i
(t)S
i
(t) v
i+1
(t)S
i+1
(t)).
The result now follows.
The implied spot rate is piecewise deterministic.
Proposition 3.4. We have for t [T
k
, T
k+1
) and T [T
i
, T
i+1
) the forward rate
f(t, T) and the spot rate r(t) given by
f(t, T) =
(v
i
(t)S
i
(t) v
i+1
(t)S
i+1
(t))
(T
i+1
T
i
)[1 +v
i+1
(t)S
i+1
(t) +(T)(v
i
(t)S
i
(t) v
i+1
(t)S
i+1
(t))]
,
and
r(t) =
(v
k
(T
k
)S
k
(T
k
) v
k+1
(T
k
)S
k+1
(T
k
))
(T
k+1
T
k
)[1 +v
k+1
(T
k
)S
k+1
(T
k
) +(t)(v
k
(T
k
)S
k
(T
k
) v
k+1
(T
k
)S
k+1
(T
k
))]
.
Proof. Forward rates are related to bond prices by f(t, T) = lnp(t, T)/T and
since (T)/T = 1/(T
i+1
T
i
) the rst result follows. We then obtain the short
rate by setting t = T (T
k
, T
k+1
).
In the next two examples we add some additional volatility and compute ap-
proximate solutions to (3.22) by assuming the familiar Ornstein-Ulhenbeck and CIR
processes for y(t).
3.5. Example: Ornstein-Uhlenbeck
Note that for ease of notation in the next two examples the pricing formula for
zero-coupon bonds will be derived using the discount factor (1 +
i
L
i
(T
i
)) and
its martingale properties but this really should be seen in terms of the auxiliary
processes Y
i
(T
i
)/Y
i+1
(T
i+1
) so that the derivation works equally well for the SMM.
Now we proceed with the example. Assume an Ornstein-Uhlenbeck process for
y(t) under the P
i+1
-measure
dy(t) = (a by(t))dt +dw
i+1
(t),
where a, b, are constants and
y(T
i
) =
ln(1 +
i
L
i
(T
i
))
T
i+1
T
i
.
Arbitrage-free interpolation of the swap curve 17
We can compute an approximate solution to the term structure in (3.22) for t
[T
k
, T
k+1
) and T [T
i
, T
i+1
),
p(t, T) =
exp(A
i
(T
i
, T, T
i+1
) y(t)(T
k+1
t))
Y
i
k+1
(t)
,
where
A
i
(T) = (T
i+1
T)
a
b
(1 e
b(TT
i
)
) + (T
i+1
T)
2
2
4b
(1 e
2b(TT
i
)
)(3.24)
C
i
(T) = (T
i+1
T
i
) (T
i+1
T)e
b(TT
i
)
, (3.25)
Y
i
k+1
(t) =
i1
j=k+1
(1 +
j
L
j
(t))(1 +
i
C
i
(T)L
i
(t)/(T
i+1
T
i
)).
In particular we have at time zero and T [T
i
, T
i+1
) we have
p(0, T) =
exp
_
(T
i+1
T)
a
b
(1 e
b(TT
i
)
) + (T
i+1
T)
2
2
4b
(1 e
2b(TT
i
)
)
_
_
1 +
i
(1 (T)e
b(TT
i
)
)L
i
(0)
_
Y
i
0
(0)
.
(3.26)
Indeed the rst expectation in the chain is
p(T
i
, T) = e
y(T
i
)(T
i+1
T
i
)
E
i+1
_
e
y(t)(T
i+1
T)
F
T
i
_
.
We know from standard theory that for t > T
i
y(t) is normally distributed with
y(t) N
_
e
b(tT
i
)
y(T
i
) +
a
b
_
1 e
b(tT
i
)
_
,
2
2b
_
1 e
2b(tT
i
)
_
_
,
and that if a variable is normally distributed with Y N(m, s
2
) we have that
E[e
Y
] = exp(m+s
2
/2).
Combining these results we have
p(T
i
, T) = e
y(T
i
)(T
i+1
T
i
)
E
i+1
(e
y(t)(T
i+1
T)
|F
T
i
) = exp(A
i
C
i
y(T
i
)),
with A
i
and C
i
as in (3.24) and (3.25). According to the boundary condition this
is equal to
e
A
i
C
i
y(T
i
)
= e
A
i
(T)
(1 +
i
L
i
(T
i
))
C
i
i
.
We make the following approximation
(1 +
i
L
i
(T
i
))
C
i
(T)
i
(1 +
i
(T)L
i
(T
i
)),
where
i
(T) =
i
C
i
(T)
i
. Note that C will be a positive function as long as b >
ln(T)/(T T
i
). Note
i
(T
i
) = 0 and
i
(T
i+1
) =
i
.
The next problem becomes that of computing
E
i
_
1
1 +
i
(T)L
i
(T
i
)
F
T
i1
_
.
18 M. Davis & V. Mataix-Pastor
We make a second approximation (1 +
i
(t)L
i
(t))
1
B
i+1
(t)/B
i
(t) so that
E
i
_
1
1 +
i
(T)L
i
(T
i
)
F
T
i1
_
1
1 +
i
(T)L
i
(T
i1
)
,
since B
i+1
/B
i
is a P
i
-martingale. The next expectation becomes
E
i1
_
1
(1 +
i1
L
i1
(T
i1
))(1 +
i
(T)L
i
(T
i1
))
F
i2
_
=
1
(1 +
i1
L
i1
(T
i2
))(1 +
i
(T)L
i
(T
i2
))
,
and so on. Hence our bond pricing formula simply becomes
p(t, T) =
e
A
i
e
y(t)(T
k+1
t)
i1
j=k+1
(1 +
j
L
j
(t))(1 +C
i
L
i
(t)/
i
)
.
In particular we obtain (3.26) at time zero.
The formula is an interpolation of todays Libor rates and function of the yield
and volatility of the short rate y(t).
Remark. The above formula works just as well if our initial data consists of swap
rates by using
1 +
k
L
k
(0) =
1 +v
k
(0)S
k
(0)
1 +v
k+1
(0)S
k+1
(0)
,
where v
k
is dened in (3.3). We then have (3.26) expressed as
p(0, T) =
exp
_
(T
i+1
T)
a
b
(1 e
b(TT
i
)
) + (T
i+1
T)
2
2
4b
(1 e
2b(TT
i
)
)
_
_
1 + (1 (T)e
b(TT
i
)
)
_
1+v
i
(0)S
i
(0)
1+v
i+1
(0)S
i+1
(0)
1
__
1+v
0
(0)S
0
(0)
1+v
i
(0)S
i
(0)
.
(3.27)
Figures (1) and (2) show examples of all three interpolations of Libor market
models studied so far; the two by Schlogl [24] and the above interpolation under
the Orstein-Uhlenbeck assumption (formula (3.26)). Figure (1) displays the instan-
taneous forwards f(t), where
f(t) =
T
lnP(0, T),
and gure (2) the discount factors implied by all three interpolations. The blue line
corresponds to the linear interpolation, the red one is Schlogls second interpolation
with a at term structure of Libor volatilities at 20%. The green line corresponds
to the Ornstein-Uhlenbeck interpolation with coecients a = b = 0.1 and = 0.2.
The three interpolations produce continuous discount factors with respect to
their maturity. Note that there is the implicit assumption that the parameters a, b
for the Ornstein-Uhlenbeck process are the same under all forward measures so the
humped shape is the same between tenors but this need not be true.
Arbitrage-free interpolation of the swap curve 19
It can be seen from the plots that Schlogls interpolations produce better be-
haved forward curves than the Ornstein-Uhlenbeck interpolation. It is also impor-
tant to note that in Schlogls interpolations a Libor Market Model alone is all that
is needed to compute discount factors for any maturity. On the other hand, in the
formula presented above (3.26) an additional stochastic process x(t) is required to
compute discount factors. However the main advantage of the method presented in
this section is that it is applicable to a swap market model while also producing a
stochastic short rate. Perhaps a renement of any of the approximations made to
arrive at formula (3.26) will produce better behaved forward curves.
Fig. 1. Comparison of the instantaneous forwards given by the three interpolations with quarterly
accrual factor. The horizontal axis represents forwards expiry T and the vertical axis the instan-
taneous forward rate
T
ln P(0, T). The blue line are forwards from the linear interpolation, the
red line from Schlogls second interpolation with Libor volatilities = 20% for all rates. The green
line are forwards from the Ornstein-Uhlenbeck interpolation with parameters a = b = 0.1 and
= 0.2.
20 M. Davis & V. Mataix-Pastor
3.6. Example: CIR model
This example computes bond prices with a CIR model for y(t) to rule out the
possibility of negative short term rates.
Assume (a, b, ) are given constants and dene y(t) as the strong solution to
dy(t) = (a by(t))dt +
_
y(t)dw
t
.
We can compute an approximate solution to the term structure in (3.22) for t
[T
k
, T
k+1
) and T [T
i
, T
i+1
) given by
p(t, T) =
exp(m
i
(T) y(t)(T
k+1
t))
Y
i
k+1
(t)
,
Fig. 2. Comparison of the three interpolations with L
i
(0) = 4% and
i
= 0.25 for i = 1, ..., 6. The
horizontal axis represents maturity T and the vertical axis the discount factor P(0, T). The blue
line represents the linear interpolation. The red line represents Schlogls second interpolation with
Libor volatilities = 20% for all Libor rates. The green line represents the Ornstein-Uhlenbeck
interpolation with parameters a = b = 0.1 and = 0.2.
Arbitrage-free interpolation of the swap curve 21
where, denoting
i
T
i+1
T
i
,
m
i
(T) =
a
2
(T
2
T
2
i
2T
i+1
(T T
i
) +
_
T
T
i
n
i
(s)ds, (3.28)
n
i
(T) =
i
(T
i+1
T)
2
(e
bT
i
e
bT
) 2b((T
i+1
T)e
bT
i
i
e
bT
)
2
(T
i+1
T)(e
bT
i
e
bT
) + 2be
bT
, (3.29)
Y
i
k+1
(t) =
i1
j=k+1
(1 +
j
L
j
(t))(1 +n
i
(T)L
i
(t)/
i
).
As before we need to compute
p(T
i
, T) = e
y(T
i
)(T
i+1
T
i
)
E
i+1
_
e
y(t)(T
i+1
T)
F
T
i
_
.
This time we use Riccati equations. Assume the solution F is of the form F(t, y(t)) =
exp(m
i
(t) n
i
(t)y(t)), then by Feynman-Kac the above is the probabilistic solution
to the following PDE
F
t
+F
y
(a by +
i+1
2
y) + 1/2
2
yF
yy
rF = 0,
F(T, y) = 1,
where r y (a by) 1/2
2
2
and = T t. By assumption on F it becomes
m ny n(a by +
i+1
2
y) + 1/2
2
yn
2
((1 +b 1/2
2
2
)y a) = 0.
We can separate into a system of ODEs with boundary conditions n(T, T) =
m(T, T) = 0
n = (b
i+1
2
)n + 1/2
2
n
2
(1 +b
i+1
1/2
2
i+1
2
),
m = a(n
i+1
).
We invoke Maple to give us an explicit solution which is given by (3.28) and (3.29).
The rest of the proof follows along the same lines as Example 3.5.
4. Missing Swap rates
In reality market data provides us with fewer swap rates than underlying dis-
count factors. Therefore in this section we study how to bootstrap the missing
data in an arbitrage-free way so that the induced volatility process is consistent
with the interpolation method. To be precise, we consider the problem where given
a SMM as in chapter four, that is a ltered probability space (, F
t
, P) support-
ing a d-dimensional Brownian motion w, but this time P being the physical mea-
sure, we have todays rates {S
i
(0)}
n1
i=1
and bounded measurable volatility func-
tions {
i
(t)}
n1
i=1
, except the value S
k
(0) and the volatility function
k
for some
22 M. Davis & V. Mataix-Pastor
k {1, ..., n 1}. We want to deduce a consistent method for obtaining these ob-
jects under arbitrage-free restrictions while preserving the positivity of the implied
Libor rate L
k
(0). We rst deal with the case where we are missing one swap rate and
then move on to see how we can extend the method to allow for more missing swap
rates. We give an example where we compute the value for the missing rates and
their volatilities explicitly. Finally we put together chapter ve and six to obtain
and HJM model from market data.
4.1. One missing swap
Before we go on to the main result of this chapter it is worth discussing a motivating
example. Lets see what happens if we try a naive interpolation method to nd a
missing swap rate. Say we have (S
n1
(0),
n1
) and (S
n3
(0),
n3
) with constant
volatilities
1
,
3
> 0 available and we dene S
n2
(t) by
S
n2
(t) =
1
2
(S
n3
(t) +S
n1
(t)).
To simplify notation let n 1 1, n 2 2, n 3 3. If we apply Itos rule
to the above under the P
n
-forward measure corresponding to the bond B
n
as the
numeraire, we have
dS
2
(t) =
1
2
S
3
(t)
3
3,n
dt +
1
2
(
3
S
3
+
1
S
1
)dw
n
, (4.1)
so that
2
:=
1
2S
2
(
3
S
3
+
1
S
1
). The process for S
2
(t) under P
n
ought to be
dS
2
=
1
2
S
1
S
2
2
+
1
(1 +
2
S
1
)
dt +
2
dw
n
. (4.2)
But from (4.1) its
dS
2
=
S
3
3
2
_
2
S
2
2
1 +
2
S
2
v
3,2
v
3
+
1
S
1
1
1 +
1
S
1
v
3,1
v
3
_
dt +
k
dw
n
. (4.3)
We need to compare the drift of (4.2) with that of (4.3) after substituting in our
interpolation for S
2
in (4.3). Simple numerical experiments show that these are not
equal. For example taking
1
=
3
= 1/2 and S
1
= S
2
= 0.03 gives a drift of
3.7e 5 when it should be 1.1e 4. These are very small values but they raise the
question, at least at the theoretical level, of how can swap rates be bootstrapped
without creating arbitrage opportunities. The reason for this inconsistency is that if
we start from an arbitrary interpolation function for the missing swap as a function
of the available data we are simultaneously specifying a volatility and a drift term
for the missing swap rate S
k
and this drift may not coincide with the drift condition
derived by Jamshidian [17] required for an arbitrage-free term structure.
In order to nd our missing swap we rst need the dynamics of S
i
(t) for t
T
i
< T
k
under the forward swap measure P
k,n
given by (3.12) in Section 3.1 and
which we rewrite below
dS
i
(t) = S
i
(t)
i
i,k
dt +S
i
(t)
i
dw
k,n
, (4.4)
Arbitrage-free interpolation of the swap curve 23
where
i,k
n1
l=k+1
l1
S
l
(t)
l
(t)
1 +
l1
S
l
(t)
v
kl
(t)
v
k
(t)
n1
j=i+1
j1
S
j
(t)
j
(t)
1 +
j1
S
j
(t)
v
ij
(t)
v
i
(t)
, (4.5)
w
k,n
is a P
k,n
-Brownian motion, and for 1 i j n 1
v
ij
(t)
n1
k=j
k
k
l=i+1
(1 +
l1
S
l
(t)), v
i
(t) v
ii
(t). (4.6)
It is important to note that v
ii
(t) at time t T
i+1
is a deterministic function of
S
i+1
(t), ..., S
n1
(t) only, so that S
i
(t) doesnt enter the expression.
We dene the missing swap S
k
= f(t, S
k+1
, ..., S
n1
) as a function f to be
determined of the remaining swap rates. This function represents an interpolating
function and it implies a particular volatility
k
for the swap rate S
k
. The next
proposition gives the consistency conditions for the pair (f, ) so that the underlying
economy of zero-coupon bonds B
i
for all i = 1, ..., n 1 is arbitrage-free.
Proposition 4.1. Let us assume be given bounded continuous R
+
-valued functions
1
(t), ...,
k1
(t),
k+1
(t), ...,
n1
(t), a vector in R
nk2
of initial values
S
1
(0), ..., S
k1
(0), S
k+1
(0), ..., S
n1
(0),
and a bounded, continuous, R
+
-valued function g
k
: R
nk2
R
+
(the subscript k
is there just to note that g
k
is a particular boundary condition dened for time T
k
).
Dene
k
:=
n1
j=k+1
S
j
j
1
f
f
S
j
, (4.7)
where the function f C
1,2
([0, T
k
]; R
nk2
) satises the following PDE (assuming
a solution exists)
f
t
+D
k+1
f = 0, (4.8)
f(T
k
, S
k+1
, ..., S
n1
) = g
k
(S
k+1
, ..., S
n1
),
with
D
k+1
=
n1
j=k+1
j
S
j
jk
j
+ 1/2
n1
ij=k+1
2
ij
.
Then, with B
n
as the numeraire, that is w
n
a P
n
-Brownian motion, S
k
(t) is given
by the solution to
dS
k
= S
k
k
n1
j=k+1
j1
S
j
t
j
v
kj
(1 +
j1
S
j
)v
k
dt +S
k
k
dw
n
. (4.9)
Moreover we can represent the solution to (5.9) by
S
k
(t) = E
k,n
[g
k
(S
k+1
(T
k
), ..., S
n1
(T
k
))|F
t
]. (4.10)
24 M. Davis & V. Mataix-Pastor
We thus have a complete market model for all swaps S
i
for i = 1, ..., n 1.
Proof. Evolve the system for i = k +1, ..., n1 under the P
k+1,n
-forward measure
as in (4.4) with k + 1 instead of k
dS
i
= S
i
i,k+1
dt +S
i
i
dw
k+1,n
,
and dene S
k
(t) = f(t, S
k+1
(t), ..., S
n1
(t)). Ito f and compare the drift and volatil-
ities with what they should look like under the P
k+1,n
measure below in (4.11)
df =
_
_
t
f +
n1
j=k+1
j
S
j
j,k+1
j
f + 1/2
n1
ij=k+1
2
ij
f
_
_
dt +
n1
j=k+1
j
S
j
j
fdw
k+1,n
,
dS
k
=
k
S
k
k,k+1
dt +
k
S
k
dw
k+1,n
. (4.11)
The volatilities must coincide, hence set
k
S
k
=
n1
j=k+1
j
S
j
j
f so that
k
=
n1
j=k+1
j
S
j
j
(lnf),
and substitute it in the drift in (4.11) to obtain
t
f +
n1
j=k+1
j
S
j
(
j,k+1
k,k+1
)
j
f + 1/2
n1
ij=k+1
2
ij
f = 0.
The result (4.9) follows since
j,k+1
k,k+1
=
_
n1
i=k+1
i1
S
i
i
1 +
i1
S
i
v
ki
v
k
n1
i=k+2
i1
S
i
i
1 +
i1
S
i
v
k+1i
v
k+1
+
n1
i=k+1
i1
S
i
i
1 +
i1
S
i
v
k+1i
v
k+1
n1
i=j+1
i1
S
i
i
1 +
i1
S
i
v
ji
v
j
_
_
=
jk
.
Notice that the dierential generator is the one for S under the P
k,n
measure hence
the probabilistic representation follows by Feynman-Kac.
We then dene the remaining swap rates as the strong solution to (4.9) where
k
is given by (4.7). In this way the corresponding SMM is consistent with an arbitrage
free term structure, that is
S
i
(t) =
B
i
(t) B
n
(t)
n
j=i+1
j1
B
j
(t)
.
Arbitrage-free interpolation of the swap curve 25
4.2. More missing rates
In reality we have more than one missing swap, say apart from missing (S
k
(0),
k
(t))
we are also missing (S
k1
(0),
k1
(t)), since the SMM is a triangular system, in the
sense that the evolution of a particular swap rate depends only on the swap rates
with later maturities, we can repeat the procedure carried out in Proposition 4.1 to
dene S
k1
as
S
k1
(t) = E
k1,n
[g
k1
(S
k
(T
k1
), ..., S
n1
(T
k1
))|F
t
], (4.12)
where S
k
(t) is dened by the SDE in Proposition 4.1. One of the key results in
Proposition 4.1 is that the boundary condition g is completely arbitrary for each
missing swap rate. The next proposition introduces a function g
kj
for a generic
missing swap rate S
kj
once all S
i
, i = k j + 1, ..., n 1 have been dened that
allows for an explicit computation of both the function f and the volatility
kj
.
Again note that the functions v
kj
depend only on S
kj+1
, ..., S
n1
.
Proposition 4.2. Let a
k
, ..., a
kj
be constants such that
a
kj
a
kj+1
... a
k
1 and a
kj
<
v
kj
(0)
v
k+1
S
k+1
(0)
,
and dene
S
kj
(t) := f
kj
(t, S
k+1
(t), ..., S
n1
(t)) =
a
kj
v
k+1
(t)S
k+1
(t)
v
kj
(t)
. (4.13)
Then the volatilities
kj
are given by
kj
=
k
i=kj+1
i
S
i
v
kj
i1
(1 +
kj
S
kj+1
)...(1 +
i2
S
i1
)v
i
(4.14)
+
k+1
v
kj
(v
kj
S
k+1
k
(1 +
kj
S
kj+1
)...(1 +
k2
S
k1
)v
k+1
)
+
n1
i=k+2
i
S
i
v
2
k
(v
kj
i
v
k+1
v
k+1
i
v
kj
).
Proof. We change measure in (4.12) to the P
k+1,n
-forward measure
dP
k+1,n
dP
k1,n
=
(T
k1
)
(t)
=
v
k+1
v
k1
(T
k1
)
v
k1
v
k+1
(t).
Notice that from the denition of v
k1
, see (4.6), the change of measure depends
only on S
k
, ..., S
n1
which have already been dened. Applying Bayes rule we have
S
k1
(t) = (t)E
k+1,n
_
g
k1
(S
k
(T
k1
), ..., S
n1
(T
k1
))
(T
k1
)
F
t
_
.
Dening
g
k1
(S
k+1
(T
k1
), ..., S
n1
(T
k1
)) := a
k1
S
k+1
(T
k1
)(T
k1
), (4.15)
26 M. Davis & V. Mataix-Pastor
(4.12) simplies to
S
k1
(t) =
a
k+1
v
k+1
(t)
v
k1
(t)
E
k+1,n
[S
k+1
(T
k1
)|S
k+1
(t)] = a
k1
v
k+1
v
k1
S
k+1
(t).
Notice that if we set a
k1
= 1 we have that the corresponding Libor rate L
k1
is
zero. Similarly for the S
kj
missing swap we have
S
kj
(t) = a
kj
v
k+1
(t)
v
kj
(t)
S
k+1
(t).
The constants a
i
are set to satisfy the positive Libor constraint v
i1
S
i1
v
i
S
i
and S
i1
1, that is
a
kj
a
kj+1
... a
k
1 and a
kj
<
v
kj
(0)
v
k+1
S
k+1
(0)
.
We can compute the volatilities in closed form. We have
f
kj
=
a
kj
v
k+1
S
k+1
v
kj
,
f
kj
kj
=
n1
i=kj+1
i
S
i
i
f
kj
.
Hence
f
kj
kj
=
k
i=kj+1
i
S
i
a
kj
v
k+1
S
k+1
i
_
1
v
kj
_
+
k+1
S
k+1
a
kj
v
k+1
i
_
S
k+1
v
kj
_
+
n1
i=k+2
i
S
i
a
kj
S
k+1
i
_
v
k+1
v
kj
_
. (4.16)
For i > k j we have
i
v
kj
=
i1
(1 +
kj
S
kj+1
)...(1 +
i2
S
i1
)v
i
.
Substitute this into equation (4.16) to obtain
f
kj
kj
=
k
i=kj+1
a
kj
i
S
i
S
k+1
v
k+1
v
2
kj
i1
(1 +
kj
S
kj+1
)...(1 +
i2
S
i1
)v
i
+
a
kj
k+1
S
k+1
v
k+1
v
2
kj
(v
kj
S
k+1
k
(1 +
kj
S
kj+1
)...(1 +
k2
S
k1
)v
k+1
)
+
n1
i=k+2
a
kj
i
S
i
S
k+1
v
2
kj
(v
kj
i
v
k+1
v
k+1
i
v
kj
).
Arbitrage-free interpolation of the swap curve 27
Hence
kj
=
k
i=kj+1
i
S
i
v
kj
i1
(1 +
kj
S
kj+1
)...(1 +
i2
S
i1
)v
i
+
k+1
v
kj
(v
kj
S
k+1
k
(1 +
kj
S
kj+1
)...(1 +
k2
S
k1
)v
k+1
)
+
n1
i=k+2
i
S
i
v
2
k
(v
kj
i
v
k+1
v
k+1
i
v
kj
).
Remark. Equation (4.10) shows that we can dene the missing swap rate S
k
as a
function `a la arrears of the available swap rates which we rewrite here
S
k
(t) = E
k,n
[g(S
k+1
(T
k
), ..., S
n1
(T
k
)|F
t
].
The resulting volatility was obtained using the PDE approach. We can use Clark-
Ocones formula to see the probabilistic relation between the interpolation (that is
the choice of function g) and the obtained volatility
k
. First we have that (4.10)
can be expressed as
S
k
(t) = E
kn
[S
k+1
(T
k
)|S
k+1
(0)] +
_
t
0
E
kn
s
[D
s
S
k
(t)]dw
k,n
(s)
= E
kn
[S
k+1
(T
k
)|S
k+1
(0)] +
_
t
0
E
kn
s
[D
s
S
k+1
(T
k
)]dw
k,n
(s),
where the last equality follows by the tower property and interchange of derivative
and conditional expectation, hence we can deduce that
k
(t) =
E
kn
[D
t
g(S(T
k
))|F
t
]
E
kn
[g(S(T
k
))|F
t
]
,
where D
t
denotes the Malliavin derivative. In particular it follows that
k
is not log-
normal since it depends on all swap rates S
k+1
, ..., S
n1
. Previously we obtained an
explicit solution for both (S
k
,
k
) because we can choose the function g to change to
a more convenient martingale measure. But for more general functions g we can use
equation (4.10) and Monte Carlo simulation to nd S
k
(0) and obtain the todays
yield curve. However Monte Carlo methods will have to be used to obtain also the
missing volatilities.
5. Yield curve dynamics and relation to HJM
In their paper [6], Brace, G atarek and Musiela introduce the Libor Market Model by
starting from an HJM model and showing how the HJM drift condition translates to
a condition on the drift of the implied model for Libor rates. The drift in the LMM,
28 M. Davis & V. Mataix-Pastor
as in the HJM, is a function of the volatilities specied for the Libor rates. In this
section we take the opposite direction and use the previous results of this paper to
obtain an HJM model from a model of Libor or swap rates and short-term rates. We
use the bootstrapping method from Section 4 to ll in the missing swaps and then
use Section 3 to interpolate between these values. At any one time, including the
present date, the interpolation is a function of the present rates and the drift and
volatility of the auxiliary process y(t) (which is calibrated to one of the short-term
rates); but as we will see below the whole curve will depend on the evolution of the
market and bootstrapped rates. Hence we can generate rich movements in the yield
curve.
The ingredients of the model are the following: a tenor structure 0 < T
1
< .... <
T
n
and accrual factors
i
T
i+1
T
i
according to some day-count convention. We
then have a co-terminal model of swap rates, that is todays swap rates, S
i
(0) for i
in some subset of {1, ..., n 1} that is fewer than dates in the tenor structure, and
their volatilities
i
. The short end of the curve is made up of short-term interest
rates and we assume for simplicity that we have two yields y
1
, y
2
, their volatilities
(
1
,
2
) and their drift coecients (a
1
, b
1
, a
2
, b
2
), (see the appendix for details).
That is B
i
(t) = e
y
i
(t)(T
i
t)
for i = 1, 2 and T
1
< T
2
. We use the process for
the yield y
1
(t) as the auxiliary process used in Section 3 to construct a continuous
time numeraire from a swap market model.
The randomness is modelled by a ltered probability space (, F, F
t
, P
SL
) sup-
porting a P
SL
-Brownian motion w where P
SL
is the measure that corresponds to
using the rolling horizon numeraire introduced in Section 3. In the Proposition be-
low we show that the bond price dynamics is a function of the short-term yield
and the volatilities of the swap rates with reset date at each tenor date. At the
tenor dates where we are missing a rate we plug in equation (4.14). This will be ne
as long as we use the swap rates from (4.13) for todays interpolation of the yield
curve. We need the following lemma which summarizes the properties of the Libor
and swap market models.
Lemma 5.1. For k < i and t [0, T
k
] the process Z
i
k
(t) 1/Y
i
k
(t) dened by
Z
i
k
(t)
1
i1
j=k
(1 +
j
L
j
(t))
=
B
i
(t)
B
k
(t)
,
follows a stochastic process under the P
k
-forward measure given by
dZ
i
k
(t) = Z
i
k
(t)
i
k
(t)dw
k
(t), (5.1)
where
i
k
(t) =
i
j=k
j
L
j
(t)
j
(t)
1 +
j
(t)L
j
(t)
. (5.2)
Under the assumptions of a swap market model, the process
Z
i
k
(t)
Y
i
(t)
Y
k
(t)
1 +v
i
(t)S
i
(t)
1 +v
k
(t)S
k
(t)
=
B
i
(t)
B
k
(t)
,
Arbitrage-free interpolation of the swap curve 29
follows under P
k
dZ
i
k
(t) =
Z
i
k
(t)
Y
k
(t)Y
i
(t)
(Y
k
(t)
i
(t) Y
i
(t)
k
(t))dw
k
(t), (5.3)
where
i
(t) =
n1
j=i+1
j1
S
j
(t)
j
(t)
1 +
j1
S
j
(t)
v
ij
(t)
v
i
(t)
+
i
(t). (5.4)
Proof. The proof of the statement for the LMM goes as follows. From Jamshidian
[17], Y
i
k
(t) under P
i
is given by
dY
i
k
(t) = Y
i
k
(t)
i
k
(t)dw
i
(t),
we apply Itos chain rule to Z
i
k
(t) 1/Y
i
k
(t) to obtain
dZ
i
k
(t) = Z
i
k
(t)
i
k
(t)dw
i
(t) +
1
2
Z
i
k
(t)
i
k
(t)
2
dt,
and changing the measure to P
k
gives the result since Z
i
k
is a martingale under that
measure.
For the swap market model we apply Itos product rule under the P
n
-measure
dZ
i
k
(t) = 1/Y
k
(t)dY
i
(t) +Y
i
(t)d(1/Y
k
(t)) +d < Y
i
, (1/Y
k
) >
t
= (1/Y
2
k
(t))(Y
k
(t)
i
(t) Y
i
(t)
k
(t))dw
n
(t) +
1
Y
2
k
(t)
_
Y
i
(t)
2
k
(t)
2Y
k
(t)
dt +
i
(t)
k
(t)
_
dt.
We now change to the P
k
measure under which Z
i
k
is a martingale to obtain
dZ
i
k
(t) = (1/Y
2
k
(t))(Y
k
(t)
i
(t) Y
i
(t)
k
(t))dw
k
(t),
and the result follows after multiplying the right hand side above by Z
i
k
Y
k
/Y
i
.
We can now prove the following Proposition which gives the bond price dynamics
using in addition to the Libor or swap market models the auxiliary process y(t)
dened in Section 3.2.
Proposition 5.1. Within the context of the Libor market model the bond price
dynamics for t [T
k
, T
k+1
), T [T
i
, T
i+1
) and
k
T
k
t, are given under the
P
k+1
-forward measure by
dp(t, T)
p(t, T)
= (y(t)
k+1
k+1
+(
1
k+1
)
2
/2+
i+1
k+1
(t, T)
1
k+1
)dt(
i+1
k+1
(t, T)+
1
k+1
)dw
k+1
,
(5.5)
where
i+1
k+1
(t, T) is dened as in (5.2) but with
i
(T) =
i
T
i+1
T
i
(T
i+1
T
i
(T
i+1
T) exp(a(T T
i
)). (5.6)
30 M. Davis & V. Mataix-Pastor
From Section 3.2 we have an implied spot rate given by
r(t) = y(t)
k+1
k+1
1/2(
1
k+1
)
2
.
Let P
k+1
)dw
t
. (5.7)
For the swap market model the equations above read under the P
k+1
measure
dp(t, T)
p(t, T)
=
_
r(t) +
1
k+1
Y
i+1
Y
k+1
(Y
k+1
k+1
Y
i+1
i+1
)
_
dt+
_
1
Y
i+1
Y
k+1
(Y
k+1
k+1
Y
i+1
i+1
) +
1
k+1
_
dw
k+1
(t),
and under the P
measure as
dp(t, T)
p(t, T)
= r(t)dt +
_
1
Y
i+1
Y
k+1
(Y
k+1
k+1
Y
i+1
i+1
) +
1
k+1
_
dw
(t),
where
Y
j
Y
j
(t, T) = 1 +v
j
(t, T)S
j
(t),
j
j
(t, T) =
n1
m=j+1
m1
S
m
(t)
m
(t)
1 +
m1
S
m
(t)
v
jm
(t, T)
v
j
(t, T)
+
j
(t), j = i + 1, k + 1.
The dependence of the random variables v
j
above on (t, T) means that they are still
dened by (3.2) but with
i
replaced by (5.6) whenever it appears.
Proof. We apply Itos product rule to equation p(t, T) = e
y(t)
k+1
/
Y
i+1
k+1
(t). For
ease of notation and as in the previous lemma let Z(t) 1/
Y
i+1
k+1
(t). The proof of
this lemma is not aected by changing
i
to
i
(T). We have
dp(t, T) = Z
t
de
y(t)
k+1
+e
y(t)
k+1
dZ
t
+d < e
y(t)
k+1
, Z >
t
= e
y(t)
k+1
Z
t
(d(y
k+1
)
t
+
1
2
d < y
k+1
>
t
) +e
y(t)
k+1
dZ
t
+d < e
y
k+1
, Z >
t
.
(5.8)
To deal with the Libor market model we substitute equation (5.1) in for Z(t) to
obtain
dp(t, T)
p(t, T)
= (y(t)
k+1
k+1
+(
1
k+1
)
2
/2)dt+
1
k+1
dw
k+1
i
k+1
dw
k+1
+
i
k+1
k+1
dt.
The result follows after rearranging. For the swap market model we let
Z(t) =
1 +v
i+1
(t)S
i+1
(t)
1 +v
k+1
(t, T)S
k+1
(t)
,
and we substitute (5.3) in (5.8) to obtain the result.
Arbitrage-free interpolation of the swap curve 31
The dynamics under the risk-neutral measure for both the Libor and swap mar-
ket models follow from Section 5.3, where we show that the market prices of risk
(t) are given by
(t) =
r(t) m(t, T)
b(t, T)
,
where m(t, T) and b(t, T) are the drift and volatility of the bond p(t, T). In this
case this is
(t) =
(
1
2
k+1
+
i+1
k+1
k+1
)
(
1
k+1
+
i+1
k+1
)
=
1
k+1
.
By Girsanov theorem the risk-neutral Brownian motion w
(t) = dw
k+1
(t) (t)dt.
We now substitute the above for w
k+1
(t) in (5.5) to obtain the result in equation
(5.7). A similar calculation works for the swap market model.
Notice that from equation (5.6), for a xed time t, the curve P(t, T) is continuous
as a function of maturity T.
Proposition 5.2. (HJM) For t [T
k
, T
k
+ 1) and T [T
i
, T
i+1
) the dynamics of
the forward rate under the risk-neutral measure P
are given by
df
t
(t, T) = (t, T)dt +(t, T)dw
t
,
where
(t, T) = (
i
k+1
(t) +
1
k+1
)
T
_
i
(T)L
i
(t)
1 +
i
(T)L
i
(t)
_
,
(t, T) =
T
i
(T)L
i
(t)
1 +
i
(T)L
i
(t)
,
i
=
i
T
i+1
T
i
(T
i+1
T
i
(T
i+1
T) exp(a(T T
i
)),
L
i
(t) =
1
i
_
1 +v
i
(t)S
i
(t)
1 +v
i+1
(t)S
i+1
(t)
1
_
,
and for t [0, T
1
) and T [T
1
, T
2
) by
df(t, T) =
_
2
M(t, T)
tT
+y
1
(t)
2
N
1
(t, T)
tT
+y
2
(t)
2
N
2
(t, T)
tT
_
dt+
_
N
1
(t, T)
T
1
+
N
2
(t, T)
T
2
_
dw
t
,
with M, N
1
, N
2
given by (A.12),(A.13) and (A.14), see the appendix for the deriva-
tions.
32 M. Davis & V. Mataix-Pastor
Proof. f(t, T) = lnp(t, T)/T.
d lnp(t, T) = rdt 1/2( +)
2
dt ( +)dw
.
Dierentiating the drift and volatility above with respect to T gives us the result.
For the short end of the curve they are given where bond prices are given by
p(t, T) = exp(M(t, T) N
1
(t, T)y
1
(t) N
2
(t, T)y
2
(t)).
Hence
f(t, T) =
T
M +y
1
(t)
T
N
1
+y
2
(t)
T
N
2
.
Dierentiate this with respect to t.
5.1. Conclusions
We now give a brief summary of the results obtained, some of its short comings and
ideas for possible future research.
We have given an example of an interpolation of the yield curve which gen-
erates arbitrage opportunities and motivated by this we have started exploring a
bootstrapping method, consistent with absence of arbitrage, for obtaining discount
factors from market data consisting of short-term rates and swap rates. That is,
we have found a deterministic function F and specied a numeraire asset B
(t),
namely the savings account of Section 3 such that for an arbitrary maturity T,
p(t, T) = F(t, T, , , S(0), (t, S(0)), a), , R
n
, S(0), , a R
k
,
and p(t, T)/B
(t) is a P
-martingale, where P
k1,k
(f)
k1
+
n1
j=k+1
j
S
j
jk
j
+ 1/2
n1
ij=k1
2
ij
.
Now the operator D
k+1
is quasi-linear through the dependence of the drift
k1,k
(given by (4.5)) on the function f. We are adding the rate S
k1
to the interpolation
but this depends, under the P
k1,n
-measure on the rate that we are trying to nd,
S
k
. Its not obvious to us how to solve this problem as the trick that we used in the
proof of Proposition 4.2 no longer applies.
Appendix A. Bond prices at the short end of the curve.
In this appendix we derive a closed-form solution for the term structure at the short
end of the curve. The rates available at the short-end of the curve consist of short-
term yields, therefore we need a dierent derivation for this section of the curve. For
this particular case we assume that our data consists of the yields y
1
(t) and y
2
(t)
of two zero-coupon bond prices B
1
(t), B
2
(t) where T
1
< T
2
. We are also given a
ltered probability space (, F
t
, P) supporting a two dimensional Brownian motion
w
1
(t), w
2
(t). At any t (T
1
, T
2
) only the yield y
2
(t) remains alive. We assume the
following process for it under the P
2
measure
dy
2
(t) = (a
2
b
2
y
2
(t))dt +
2
dw
2
(t), (A.1)
where a
2
, b
2
,
2
are constants with
2
2
> 0. For t [0, T
1
] we assume a similar
process for y
1
under the P
1
forward measure with (a
1
, b
1
,
1
) constants and
2
1
> 0,
dy
1
(t) = (a
1
b
1
y
1
(t))dt +
1
dw
1
(t). (A.2)
The process for y
2
for t [0, T
1
] under P
1
is given however by
dy
2
(t) =
2,1
(t)dt +
2
dw
2,1
(t), (A.3)
where
2,1
is the drift under this forward measure, making sure that B
2
/B
1
follows
a P
1
-martingale. Denote by w
2,1
the Brownian motion driving the yield y
2
under
the P
1
measure with dw
1
dw
1,2
= dt.
34 M. Davis & V. Mataix-Pastor
Lemma Appendix A.1. Assume t [0, T
1
] and y
1
(t) satises under the P
1
-
forward measure
dy
1
(t) = (a
1
b
1
y
1
(t))dt +
1
dw
1
(t). (A.4)
Then under P
1
y
2
(t) is given by the strong solution to
dy
2
(t) =
1
2
(y
2
(t) y
1
(t)(1 +b
1
1
) +a
1
1
+)dt +
2
dw
2,1
(t), (A.5)
where
i
= T
i
t and :=
1
2
(
2
1
2
1
+
2
2
2
2
)
1
2
. Furthermore the solution
to these are given by
y
1
(t) = e
b
1
t
y
1
(0) +
a
1
b
1
(1 e
b
1
t
) +
1
_
t
0
e
b
1
(tu)
dw
1
(u),
2
y
2
(t) = T
2
y
2
(0) y
1
(0)h
1
(t) +h
2
(t) + (t),
+
1
_
t
0
u T
1
+e
b
1
u
(T
1
t)dw
1
+
2
_
t
0
T
2
udw
2,1
(u),
where
h
1
(t) :=
1
b
1
(1 e
b
1
t
)(b
1
T
1
+te
b
1
t
),
h
2
(t) :=
a
1
b
1
((T
1
t)(1 e
b
!
t
) b
1
tT
1
) +at
2
/2,
(t) := a
1
t
_
T
1
t
2
_
+
t
2
2
i=1
2
i
_
T
2
i
+
t
2
3
2T
i
_
+
1
2
t
_
T
1
T
2
+
t
2
3
(T
1
+T
2
)
_
.
Hence y
1
(t) N(m
1
, s
2
1
) and y
2
(t) N(m
2
, s
2
2
) with
m
1
(t) = y
1
(0)e
b
1
t
+
a
1
b
1
_
1 e
b
1
(tT
i
)
_
,
s
2
1
(t) =
2
2b
1
_
1 e
2b
1
(tT
i
)
_
, (A.6)
m
2
(t) =
1
2
(T
2
y
2
(0) h
1
(t)y
1
(0) +h
2
(t) + (t)), (A.7)
s
2
2
(t) =
2
1
(T
1
t)
b
2
1
(1 e
b
1
t
)((1 b
1
T
1
)
2
(1 b
1
T
2
))
+
1
(T
1
t)
2
2b
1
(1 e
2b
1
t
)
2
1
(T
1
t)t
b
1
(1 +
2
)e
b
1
t
(A.8)
+t
_
2
T
2
2
1
T
2
1
2
1
2
T
1
T
2
+t(
1
T
1
2
T
2
+ (T
1
+T
2
)
1
2
) +
t
2
3
(
2
1
2
1
2
)
_
.
Proof. We require the following ratios to follow martingales:
B
2
(t)
B
1
(t)
= exp(y
1
(t)(T
1
t) y
2
(t)(T
2
t)). (A.9)
Arbitrage-free interpolation of the swap curve 35
Let
f(t, y
2
, y
1
) := exp(y
1
(t)(T
1
t) y
2
(t)(T
2
t)).
Applying Itos Lemma we obtain
df(t, y(t))
f(t, y(t))
= ((y
2
y
1
)
2,1
(T
2
t) +
1
(T
1
t) + 1/2(T
2
t)
2
2
2
+ 1/2(T
1
t)
2
1
1
(T
2
t)(T
1
t)
2
1
)dt
2
2
dw
2,1
+
1
1
dw
1
.
(A.10)
Setting
2,1
as in (A.5) the drift term cancels and hence (A.9) will follow a martin-
gale. The solution to (A.4) follows by standard theory. The solution to (A.5) is a
bit more involved. Let I(t) =
_
t
0
1/(T
2
s)ds be an integrating factor. Then
d(e
I(t)
y
2
(t)) = e
I(t)
dy
2
(t)
y
2
(t)
T
2
t
e
I(t)
dt
=
e
I(t)
T
2
t
(y
1
(t)(1 +b
1
1
) +a
1
1
+)dt +e
I(t)
2
dw
2,1
.
A simple calculation gives e
I(t)
= T
2
/(T
2
t), hence
y
2
(t) = e
I(t)
y
2
(0) +e
I(t)
_
t
0
e
I(t)
T
2
s
(y
1
(t)(1 +b
1
1
) +a
1
1
+)dt +e
I(t)
_
t
0
e
I(s)
2
dw
2,1
=
T
2
T
2
t
y
2
(0) +
1
T
2
t
_
t
0
y
1
(s)(1 +b
1
1
) +a
1
1
+(s)ds +
2
T
2
t
_
t
0
(T
2
s)dw
2,1
.
We analyse the integrals in detail. First
_
t
0
y
1
(s)ds =
y
1
(0)
b
1
(1 e
bt
) +
a
1
b
1
(t
1
b
1
(1 e
b
1
t
)) +
1
b
1
_
t
0
1 e
b
1
(tu)
dw
1
(u)
_
t
0
y
1
(s)sds = y
1
(0)
_
t
0
se
b
1
s
ds +
a
1
b
1
_
t
0
s(1 e
b
1
s
)ds +
1
_
t
0
s
_
s
0
e
b
1
(su)
dw
1
(u)ds
=
1
b
1
_
y
1
(0)
a
1
b
1
__
1
b
1
_
1 e
b
1
t
_
te
b
1
t
_
+
a
1
t
2
2b
1
+
1
b
1
_
t
0
u +
1
b
1
_
t +
1
b
1
_
e
b
1
(tu)
dw
1
(u),
_
t
0
a(T
1
s) +ds = a
1
(T
1
t
t
2
2
) +
1
2
2
i=1
2
i
(T
2
i
t +
t
3
3
2T
i
t)
+
1
2
(T
1
T
2
t +
t
3
3
t(T
1
+T
2
)).
Rearranging gives us the result.
36 M. Davis & V. Mataix-Pastor
We then have the main result of this subsection.
Proposition Appendix A.1. Assume a process for (y
1
(t), y
2
(t)) given by (A.1),
(A.4) and (A.5). Then for t [0, T
1
] and T [T
1
, T
2
] the term structure is given by
p(t, T) = exp(M(t, T) N
1
(t, T)y
1
(t) N
2
(t, T)y
2
(t)), (A.11)
where
M(t, T) = AT
1
a
1
b
1
(1 e
b
1
t
2
h
2
(T
1
) + 1/2(T
2
1
s
2
1
+C
2
s
2
2
), (A.12)
N
1
(t, T) = e
b
1
T
1
T
1
2
h
2
(T
1
), (A.13)
N
2
(t, T) = CT
2
/
2
, (A.14)
C = (T
2
T) exp(b
2
(T T
1
)), (A.15)
A = (T
2
T)
a
2
b
2
_
1 e
b
2
(TT
1
)
_
+ (T
2
T)
2
2
4b
2
_
1 e
2b
2
(TT
1
)
_
. (A.16)
Proof. We want to evaluate p(0, T) where T
1
< T < T
2
,
p(t, T) = E
1
_
e
y
1
(T
1
)T
1
E
2
[e
y
2
(T)(T
2
T)
|F
1
]|F
t
_
= E
1
_
e
y
1
(T
1
)T
1
e
ACy
2
(T
1
)
|F
t
_
, (A.17)
with C and A given by (A.15) and (A.16) respectively. The equality in (A.17) is
obtained by applying the result in Section 3.5 to the expectation in the P
2
-forward
measure with the process for y
2
given in (A.1). We have the processes for (y
1
, y
2
)
under the P
1
-forward measure given by (A.6) and (A.6). We can rewrite (A.17) as
p(0, T) = e
A(T)
E
1
_
e
y(T
1
)
|F
0
_
,
where y = T
1
y
1
(T
1
) Cy
2
(T
1
) implying that y N(m, s
2
) with (using (A.6) to
(A.8)
m = T
1
E
1
y
1
CE
1
y
2
= T
1
m
1
(T
1
) Cm
2
(T
1
),
s
2
= T
2
1
var(y
1
) +C
2
var(y
2
)
= T
2
1
s
2
1
+C
2
s
2
2
.
Hence
p(t, T) = exp(A+m+s
2
/2).
Rearranging we obtain the result in (A.11)
p(t, T) = exp(M(t, T) N
1
(t, T)y
1
(t) N
2
(t, T)y
2
(t)).
Arbitrage-free interpolation of the swap curve 37
Acknowledgments
We would like to thank Lane Hughston, Andrew Cairns and Stefano Galluccio for
helpful comments and suggestions. Mataix-Pastor received funding from Instituto
de Credito Ocial (ICO, Spain) and Fundacion Caja Madrid (Spain).
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