Real World Interest Rate Modelling with the BGM Model

Abstract

This paper presents an interest rate model for real world risk management purposes which produces realistic yield curve movements, does not allow negative interest rates and is arbitrage free. The model is formulated in the BGM framework, with market prices of risk which limit the occurrence of "implausible" yield curve shapes. The paper illustrates a simple calibration procedure to obtain parameter estimates from historical data. Extensions of the model, such as a constant elasticity of variance model, are proposed and investigated.