Economy – Quantitative Finance – Pricing of Securities
Scientific paper
2008-02-09
Annals of Applied Probability 2009, Vol. 19, No. 4, 1553-1580
Economy
Quantitative Finance
Pricing of Securities
Published in at http://dx.doi.org/10.1214/08-AAP586 the Annals of Applied Probability (http://www.imstat.org/aap/) by the Inst
Scientific paper
10.1214/08-AAP586
In this work we introduce Heath-Jarrow-Morton (HJM) interest rate models driven by fractional Brownian motions. By using support arguments we prove that the resulting model is arbitrage free under proportional transaction costs in the same spirit of Guasoni [Math. Finance 16 (2006) 569-582]. In particular, we obtain a drift condition which is similar in nature to the classical HJM no-arbitrage drift restriction. The second part of this paper deals with consistency problems related to the fractional HJM dynamics. We give a fairly complete characterization of finite-dimensional invariant manifolds for HJM models with fractional Brownian motion by means of Nagumo-type conditions. As an application, we investigate consistency of Nelson-Siegel family with respect to Ho-Lee and Hull-White models. It turns out that similar to the Brownian case such a family does not go well with the fractional HJM dynamics with deterministic volatility. In fact, there is no nontrivial fractional interest rate model consistent with the Nelson-Siegel family.
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