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IAI Actuarial Core Principles · Economic Modelling · Models of the term structure of interest rates

In a Heath–Jarrow–Morton (HJM) model, which feature is a key reason it is described as modelling the whole yield curve directly?

HJM models the evolution of the whole forward rate curve, with the drift fixed by no-arbitrage once the volatility structure is chosen. This lets it fit the initial yield curve exactly, unlike single short-rate models.

  1. AIt models the short rate as a single mean-reverting process only
  2. BIt models the evolution of the entire instantaneous forward rate curve, with the drift determined by the volatility structure under no-arbitrageCorrect
  3. CIt assumes forward rates are constant over time
  4. DIt requires the yield curve to be flat
  5. It models bond prices as independent of one another

Explanation

HJM specifies the dynamics of f(t,T) for all T. No-arbitrage under the risk-neutral measure fixes the drift in terms of the volatilities, so only volatilities need to be specified. The other options contradict this.

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