The volatility structure of the fixed income market under the HJM framework: A nonlinear filtering approach

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Journal Article
Computational Statistics and Data Analysis, 2009, 53 (6), pp. 2075 - 2088
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The dynamics for interest rate processes within the well-known multi-factor Heath, Jarrow and Morton (HJM) specification are considered. Despite the flexibility of and the notable advances in theoretical research about the HJM model, the number of empirical studies of it is still very sparse. This paucity is principally due to the difficulties in estimating models in this class, which are not only high-dimensional, but also nonlinear and involve latent state variables. The estimation of a fairly broad class of HJM models as a nonlinear filtering problem is undertaken by adopting the local linearization filter, which is known to have some desirable statistical and numerical features, so enabling the estimation of the model via the maximum likelihood method. The estimator is then applied to the US, the UK and the Australian markets. Different two- and three-factor models are found to be the best for each market, with the factors being the level, the slope and the twist effect. The contribution of each factor towards overall variability of the interest rates and the financial reward each factor claims are found to differ considerably from one market to another.
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