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Implementing HJM Model in Python

The document discusses implementing the Heath-Jarrow-Morton model in Python to model forward interest rates using a differential equation that allows for randomness. It outlines the assumptions of the HJM model and its uses for pricing securities and derivatives. It also describes calibrating the HJM model with historical yield curve data and using principal component analysis and Monte Carlo simulation to price an interest rate caplet.

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Rodro1608
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314 views

Implementing HJM Model in Python

The document discusses implementing the Heath-Jarrow-Morton model in Python to model forward interest rates using a differential equation that allows for randomness. It outlines the assumptions of the HJM model and its uses for pricing securities and derivatives. It also describes calibrating the HJM model with historical yield curve data and using principal component analysis and Monte Carlo simulation to price an interest rate caplet.

Uploaded by

Rodro1608
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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IMPLEMENTING HEATH-JARROW-MORTON

MODEL (HJM) AND CALIBRATION IN PYTHON


AARON DE LA ROSA
The Heath-Jarrow-Morton Model (HJM Model) is used to model forward interest rates using a
differential equation that allows for randomness. These rates are modeled to an existing term structure
of interest rates to determine appropriate prices for interest-rate sensitive securities such as bonds or
swaps.
1.The HJM framework specifies forward rates dynamics directly.
2.Forward rate drift fully determined by volatility (HJM) Model. Initial Forward rate curve exogenous.
3.HJM framework contains all interest rate models driven by Brownian Motion.
ASSUMPTIONS OF HJM MODEL
1. HJM Model assumes that the forward rate is driven by volatility because can be predicted in the
futures market contracts.
2. El price of each security is observable. The security can be bought and sold at any quantity at
the observed price.
3. The model does not explain all the complexities that come from a changing term structure.

USES OF HJM MODEL

1. Investors use HJM model to determine the price of securities which are affected by interest rate
fluctuations. By being able to price securities, investors can engage in arbitrage opportunities to
earn a riskless profit if there are differences between security price in the market and security
price based on HJM Model.
2. HJM Model can be used to price financial derivatives because the value of derivatives depends
on the term structure of underlying assets. For example, the underlying asset for credit
derivatives is the price of risky-zero coupon bonds.
3. It can be used in asset-liability management.
CAPLET
Caplets are interest rate options designed to cap the risk of rising interest. These options use an
interest rate, rather than a price, as basis for a strike. Caplets are shorter term (90 days) in
duration.
HJM CALIBRATION AND PRICING

We calibrate HJM Model with historical daily yield curve data over the last five years. The yield
curve structure contains 51 patterns ranging from 1 Month to 25 years. The principal component
analysis is used to identify common factors which are driving movements in rates. Typically, 3-5
factors are sufficient to explain dynamics of the yield curve. Once the volatility factors are
identified in historical data by PCA technique, cubic spline interpolation is used to fit these
factors. This interpolation is used to generate discrete mesh of tenors for the purpose of Monte
Carlo Simulation. Risk- Neutral Drift Function is calculated using numerical integration over fitted
volatility functions. We price an Interest Rate Caplet with strike 3% using Monte Carlo Simulation.

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