On Gaussian HJM framework for Eurodollar Futures

Abstract

One of the standard tools for the theoretical analysis of fixed income securities and their associated derivatives is the term structure model of Heath, Jarrow and Morton. In this paper the question, what specific HJM model is consistent with the observed price of an Eurodollar Futures contract? is discussed. Eurodollar Futures, apart from being the most heavily traded futures are connected to London Inter Bank Offered Rate (LIBOR) and to domestic monetary conditions. The answer to the above question will help in pricing any new derivative on Eurodollar Futures or the one that is not heavily traded. A simple tool to measure the adequacy of different HJM structures that may be used to model Eurodollar Futures price process is suggested. Moreover, the question of estimation of parameters of these models by different methods—method of realized volatility, method of maximum likelihood (ML) and a two‐stage method that combines both the realized volatility and ML—is addressed. Although it sounds like a typical statistical procedure, one must be careful in applying standard statistical techniques that are not suitable under arbitrage theory, in particular, ML method. Copyright © 2010 John Wiley & Sons, Ltd.