Interest Rate Dynamics and Consistent Forward Rate Curves

Abstract

We consider, as given, an arbitrage-free interest rate model 'M' and a parametrized family of forward rate curves 'g'. We study the question as to when the given family 'g' is consistent with the dynamics of the interest rate model 'M', in the sense that 'M' actually will produce forward rate curves belonging to 'g'. We allow the interest rate model to be driven by a multidimensional Wiener process, as well as by a marked point process, and we give necessary and sufficient conditions for consistency. As test cases, we study some popular models, obtaining both positive and negative results about consistency. We also introduce a natural exponential-polynomial family of forward rate curves, and for this family we give necessary and sufficient conditions for the existence of consistent interest rate models with deterministic volatility functions.