In this thesis, we will use Heath, Jarrow, and Morton(HJM) model for pricing vanilla floating rate notes and analyze the result.
To price floating rate notes, we need to predict future interest rates. Equilibrium models start with a model of the economy and derive a model for the behavior of interest rates. Rendleman and Barter model, Vasicek model and CIR(Cox, Ingersoll, and Ross) model are examples of equilibrium model. However, equilibrium models do not fit today`s term structure automatically. Unlike equilibrium models, No-arbitrage models fit today`s term structure. Ho-Lee model and Hull-White model are examples of no-arbitrage models. Heath, Jarrow, and Morton(HJM) model is a model for forward rate.
Since the HJM model is a model for the yield curve expressed in terms of the processes followed by instantaneous forward rates, we can assume that it reflects reasonable expected interest rates. We get the theoretical prices of FRNs by using the Heath, Jarrow, and Morton model. There are some differences between theoretical and real prices of FRN. The theoretical prices of FRNs are generally higher than the real prices of FRNs. First of all, we can consider our coefficients of model are different from that of real model. Secondly. we can consider these differences are coming from credit risks and premium for liquidity.