23.

Single-Period Binomial Heath–Jarrow–Morton Model

23.1 Introduction Summary:

This chapter introduces the Heath–Jarrow–Morton (HJM) model for valuing interest rate
derivatives within a binomial model framework. It shares similarities with the binomial
option pricing model from Chapter 17, employing no-arbitrage and hedging arguments to
value interest rate derivatives. However, a key difference lies in the introduction of a term
structure of interest rates that fluctuates randomly over time, creating a new world of interest
rate derivatives reminiscent of Alice's adventures in Wonderland.

The chapter explores this novel landscape, likening characters such as forward rates and zero-
coupon bond prices to the Cheshire Cat and Mad Hatter, aiding in the search for the interest
rate derivative's hedge ratio, represented as the white rabbit. While earlier chapters covered
interest rate derivatives with linear payoffs (FRAs and swaps), the current analysis extends to
derivatives with nonlinear payoffs, including futures contracts, interest rate call and put
options (caplets and floorlets), and their portfolios known as caps and floors.

The historical context of interest rate derivatives models is presented before delving into the
single-period binomial HJM model. Drawing parallels with the binomial option pricing
model, the chapter piggybacks on the previous material to simplify the presentation. Key
steps involve stating assumptions, constructing synthetic caplets for valuation, determining
the caplet's arbitrage-free price, and exploring concepts like hedge ratio, martingale pricing,
and risk-neutral valuation. The chapter introduces caplet and floorlet parity, analogous to put–
call parity, and concludes with a discussion of alternative interest rate derivatives valuation.

Chapter 24 is highlighted as an extension to the single period, introducing a multiperiod

setting to generate a practical HJM model. A final note emphasizes the use of Excel-based
software, Priced!, for computations, ensuring more than sixteen-digit accuracy. However, for
simplicity, reported results are rounded to four decimal places, with a cautionary note about
potential differences in evaluated expressions compared to those based on the higher
precision. This issue is acknowledged as a typical challenge in reporting numerical
computations.

23.2 Summary: The Basic Interest Rate Derivatives

In the realm of interest rate derivatives, akin to other financial markets, four fundamental
instruments exist: forwards, futures, call options, and put options. However, in this context,
the default-free spot rate of interest serves as the underlying "index." Call and put options are
referred to as caplets and floorlets, respectively, in the world of interest rate derivatives.
Notably, caplets and floorlets do not trade independently but rather function within portfolios
known as caps and floors, respectively. This portfolio-based trading strategy is employed to
optimize transaction costs. These portfolio securities play a crucial role in hedging fixed- and
floating-rate coupon bonds, aligning with the multiple cash flows associated with coupon
bonds.

Given the complexity of coupon bonds with multiple cash flows, the decision to trade basic
hedging instruments as portfolios is logical. Additionally, in the interest rate derivatives
domain, forwards take on distinct forms, trading separately as Forward Rate Agreements
(FRAs) and within portfolios known as interest rate swaps. The chapter presents a summary
of these four basic derivatives in Table 23.1, followed by detailed descriptions highlighting
their roles and applications in the interest rate markets.

no TABLE 23.1: The Basic Interest Rate Derivatives

Today Intermediate Date Maturity Date
1 Forwards: forward rate No cash flows. Short pays buyer the spot
agreements (FRAs) rate minus the FRA rate,
Buyer negotiates FRA applied on a notional
rate (which is equiva- amount and computed over
lent to the forward rate) a fixed time interval.
and contract terms with
the seller. No cash
changes hands today.
2 Futures: Eurodollar Marking-to-market cash Cash settlement based on a
futures contracts flows. notional quantity computed
Regulated, standardized over a fixed time period.
contracts betting on a
simple interest rate
(bbalibor) to be realized
at a future date. No cash
changes hands today.
3 Call options: caplets Caplet buyer receives the Same as in intermediate
A cap buyer pays a spot rate less the cap rate if date.
premium and buys a positive, or zero otherwise.
portfolio of European
calls of different
maturities on the same
notional principal. The
underlying is a simple
interest rate (bbalibor). A
caplet is one of those
European calls.
4 Put options: floorlets Floorlet buyer receives the Same as in intermediate
A floor buyer pays a floor rate minus the spot date.
premium and buys a rate if positive, or zero
portfolio of European put otherwise.
 options of different
maturities on the same
notional principal. The
underlying is a simple
interest rate (bbalibor).
A floorlet is one of those
European puts.
1. Forwards and Forward Rate Agreements (FRAs):
 A Forward Rate Agreement (FRA) is an over-the-counter (OTC) contract that
fixes an interest rate for borrowing or lending over a future time period.
 The FRA rate is equivalent to the forward rate, which serves as a fundamental
building block in the theory.
 Interest rate swaps, discussed in Chapter 22, constitute portfolios of zero-
coupon bonds and FRAs.
2. Futures:
 Interest rate futures are exchange-traded contracts that fix a borrowing or
lending rate at a specified future date.
 Differentiating from FRAs, futures contracts have features like
standardization, involvement of a clearinghouse, margins, and daily
settlements for enhanced safety and ease of trading.
 Some interest rate futures, such as those on Treasuries, result in physical
delivery, while others, like Eurodollars, conclude with cash settlement.
3. Call Options (Caplets and Caps):
 A caplet is a European call option on an interest rate effective for a single
period.
 The buyer of a caplet receives payment equal to the positive difference
between the spot rate and the cap rate; otherwise, no payment is made.
 A cap represents a portfolio of caplets and is typically cash-settled, often based
on benchmarks like bbalibor.
4. Put Options (Floorlets and Floors):
 A floorlet is a European put option on an interest rate effective for a single
period.
 The buyer of a floorlet receives payment equal to the positive difference
between the floor rate and the spot rate; otherwise, no payment is made.
 A floor represents a portfolio of floorlets and is typically cash-settled, often
based on benchmarks like bbalibor.
23.3 A Brief History of Interest Rate Derivatives Models
In their book Financial Calculus—An Introduction to Derivatives Pricing, Baxter and Rennie
(1996, p. 203) wrote.1 The development of interest rate derivatives models has a historical
context that underscores the challenges and evolution of pricing these complex financial
instruments.2

1. Historical Background:
- While the term structure of interest rates has been a subject of academic study for a long
time, derivatives pricing models specifically emerged in the last quarter of the twentieth
century.
- Pricing interest rate derivatives is challenging due to the intricate task of modeling the
evolution of the term structure of interest rates, considering the correlation between long-,
middle-, and short-term rates as they move randomly through time.

2. Spot Rate Models:

- Early models, known as spot rate models, focused on the evolution of the spot rate,
represented by R(t).
- Examples include models by Vasicek (1977), Brennan and Schwartz (1979), and Cox et
al. (1985).
- Spot rate models faced limitations, such as dependency on interest rate risk premia and
challenges in matching the initial yield curve accurately, which is crucial for pricing and
hedging.

3. HJM Model (Heath–Jarrow–Morton):

- The HJM model addressed the limitations of spot rate models.
- A precursor to the HJM model was presented by Ho and Lee (1986), with Black et al.
(1990) developing a related model.
- Heath, Jarrow, and Morton succeeded in building a general arbitrage-free model for
discount bond dynamics and contingent claim valuation.
- The HJM model, introduced in 1987 and published in 1990 and 1992, is a continuous-time
and multifactor model, encompassing all previous spot rate models as special cases.

4. Libor Model:
1
Shiller (1989) provides a comprehensive discussion of the fundamental concepts, theories, and empirical
studies of the classical term structure literature.
2
See Hughston (1996) and Ho and Lee (2004), chapter 5, for additional histories of interest rate derivatives
models.
 - A popular subcase of the HJM model is the libor model (or market model or BGM model),
widely used by Wall Street.
- Independently developed by Sandmann et al. (1995), Miltersen et al. (1997), and Brace et
al. (1997), the libor model employs simple bbalibor rates instead of continuously
compounded spot or forward rates.
- This model has gained popularity for its formulaic simplicity, generating a caplet formula
analogous to the Black-Scholes-Merton European call option formula.
The HJM model, and its subcase, the libor model, represent significant advancements in
interest rate derivatives modeling, providing a comprehensive framework for valuation and
risk management. Industry professionals often use proprietary versions of these models for
practical applications in financial markets.

23.4 The Assumptions

The single binomial Heath-Jarrow-Morton (HJM) model builds upon the binomial option
pricing model from chapter 17, with key modifications. Unlike the earlier assumption A6 that
ruled out interest rate uncertainty, this model relaxes that constraint. Additionally, assumption
A7, which described the evolution of stock prices, is replaced by a more intricate assumption
governing the random evolution of the term structure of interest rates.
Before delving into these modifications, let's revisit assumptions A1-A5:
A1. No market frictions: Trading is assumed to be free of market frictions such as transaction
costs, margin requirements, short sale restrictions, and taxes. Assets are perfectly divisible,
providing a benchmark model for later addition of frictions. This assumption is a reasonable
approximation for institutional traders.
A2. No credit risk: The model assumes the absence of credit risk, also known as default or
counterparty risk. This risk pertains to the possibility of a counterparty failing to fulfill an
obligation. The absence of credit risk is considered reasonable for both exchange-traded
derivatives and many over-the-counter (OTC) derivatives due to collateral provisions.
A3. Competitive and well-functioning markets: In competitive markets, traders act as price
takers, preventing price manipulation. In well-functioning markets, there is consensus on
zero-probability events, eliminating arbitrage opportunities. Price bubbles, causing a wedge
between an asset's market price and its intrinsic value, are assumed to be absent.
A4. No intermediate cash flows: Assets are assumed to provide no intermediate cash flows,
such as dividends for stocks or coupon income for bonds. The model can easily incorporate
such cash flows later.
A5. No arbitrage opportunities: The model prohibits the existence of arbitrage opportunities.
where B(t,T) is the time t price of a zero-coupon bond maturing at time T. When the time t
forward rate corresponds to the immediate future period [t, t 1], the forward rate gets a special
name, the spot rate, and is denoted by f(t,t) R(t).
The term structure of forward rates and zero-coupon bond prices are mutually
interchangeable, allowing for easy computation between the two. Chapter 21 (Result 21.2)
demonstrates how to calculate the term structure of zero-coupon bond prices from the
forward rates. Conversely, expression (23.4) reveals that given the term structure of zero-
coupon bond prices, one can readily obtain the term structure of forward rates. This
equivalence signifies that both structures carry the same information about the evolution of
interest rates.
To describe the evolution of the term structure of interest rates, one can impose an
assumption on either the forward rates or the zero-coupon bond prices. In discrete-time
models, it is often clearer to impose the assumption on the zero-coupon bond prices for
pedagogical reasons. However, for parameter estimation, transforming the evolution of zero-
coupon bond prices to that of forward rates becomes necessary, as the latter's evolution is
more time-stationary, aligning with statistical estimation procedures (see chapter 21).
In continuous-time models, the approach reverses. It is more straightforward to directly
impose the term structure evolution assumption on forward rates. This is evident in chapter
25 when discussing the HJM Libor model. Importantly, both approaches are equivalent ways
of imposing the same assumption.
EXAMPLE 23.3 The Single-Period Term Structure Evolution
The lower part of Figure 23.2 gives the formalization of this example using the symbols
introduced in assumption A6.