The HJM framework demonstrates that when the money market account is used as numeraire, forward rates are not martingales but have a non-zero drift term fully determined by the forward rate volatility. Hence, only the forward rate volatilities are needed to price and hedge interest rate contingent claims. To begin an implementation of HJM, the form of the forward rate volatility function must be specified. Consider the differential form of equation (11.32), the forward rate process under the martingale measure1:
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© 2004 Simona Svoboda
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Svoboda, S. (2004). Calibration of the Heath, Jarrow and Morton framework. In: Interest Rate Modelling. Finance and Capital Markets Series. Palgrave Macmillan, London. https://doi.org/10.1057/9781403946027_15
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DOI: https://doi.org/10.1057/9781403946027_15
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