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The Economic Research Institute, Stockholm School of Economics SSE/EFI Working Paper Series in Economics and Finance

No 498:
Finite dimensional Markovian realizations for stochastic volatility forward rate models

Tomas Björk (), Camilla Landén and Lars Svensson ()

Abstract: We consider forward rate rate models of HJM type, as well as more general infinite dimensional SDEs, where the volatility/diffusion term is stochastic in the sense of being driven by a separate hidden Markov process.

Within this framework we use the previously developed Hilbert space realization theory in order provide general necessary and sufficent conditions for the existence of a finite dimensional Markovian realizations for the stochastic volatility models. We illustrate the theory by analyzing a number of concrete examples.

Keywords: HJM models; stochastic volatility; factor models; forward rates; state space models; Markovian realizations; infinite dimensional SDEs; (follow links to similar papers)

JEL-Codes: E43; G13; (follow links to similar papers)

47 pages, April 29, 2002, Revised May 7, 2002

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