On Pricing Kernels and Finite State Variable Heath Jarrow Morton Models

Abstract

Once a pricing kernel is established, bond prices and all other interest rate claims can be computed. Alternatively, the pricing kernel can be deduced from observed prices of bonds and selected interest rate claims. Examples of the former approach include the celebrated Cox, Ingersoll and Ross (1985) model and the more recent model of Constantinides (1992). Examples of the latter include the Black, Derman and Toy (1990) model and the Heath, Jarrow and Morton paradigm (1992) (hereafter HJM). In general, these latter models are not Markov. Fortunately, when suitable restrictions are imposed on the class of volatility structures of forward rates, then finite state variable HJM models do emerge. This article provides a linkage between the finite state variable HJM models, which use observables to induce a pricing kernel, and the alternative approach, which proceeds directly to price after a complete specification of a pricing kernel. Given such linkages, we are able to explicitly reveal the relationship between state-variable models, such as Cox, Ingersoll and Ross, and the finite state-variable HJM models. In particular, our analysis identifies the unique map between the set of investor forecasts about future levels of the drift of the pricing kernel and the manner by which these forecasts are revised, to the shape of the term structure and its volatility. For an economy with square root innovations, the exact mapping is made transparent.

JEL Classification: G13, E43, G12