BFS 2002

Contributed Talk

Finite Dimensional Markovian Realizations for Stochastic Volatility Forward Rate Models

Tomas Björk, Camilla Landen, Lars Svensson

We consider forward rate rate models of Heath-Jarrow-Morton 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 abstract realization theory developed by Björk and Svensson 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.