An Empiri

al Investigation of the Quantum Field Theory of Forward Rates

Marakani Srikant and Belal E. Baaquie
Permanent address: Department of Physi s, National University of Singapore, Kent Ridge Road, Singapore 091174

The quantum theory of forward rates is investigated using daily eurodollar futures data from the
1980s and 1990s. It is found that a one fa tor quantum eld theoreti model is suÆ ient to explain
the observed rates. It is also shown that a one fa tor HJM model is in onsistent with the observed
rates.

I. INTRODUCTION

The earliest arbitrage pri ing interest rate models (eg., Vasi ek [1℄) dealt only with the spot rate and the forward
rate urve was treated as a derived quantity. These were found to be insuÆ ient for pra ti al purposes due to problems
involving the inversion of the term stru ture to obtain the market pri es of risk. The Ho-Lee [2℄ and Heath-Jarrow-
Morton (HJM) [3℄ models were developed to deal with this problem by modelling the entire forward rate urve (FRC)
rather than just the spot rate. The HJM model is, however, limited in the sense that the Brownian motions on whi h
the HJM e onomy depends are independent of the maturity time of the bonds. One way of removing this restri tion
is by using a formulation involving quantum eld theory as in Baaquie [4℄. Another way is to use the idea of random
elds as in Goldstein [5℄. Both these approa hes are losely related.
Following Bou haud [6℄, we use the eurodollar futures data as a dire t measure of the forward rate urve. In this
paper, we use daily histori al eurodollar futures data to ompare the performan e of the one fa tor HJM and quantum
eld theoreti models.
Several empiri al tests of the HJM model have been performed (eg., Buhler, Uhrig-Homburg, Walter and Weber
[7℄, Flesker [8℄, Sim and Thurston [9℄) with mixed results. Most of the tests assume a ertain form for the volatility
fun tion. In this paper, we propose a test whi h is independent of the volatility fun tion. This test is, however,
restri ted to the one fa tor model.
Baaquie [4℄ models the forward rate urve as a quantum me hani al string with nite tension whi h evolves in a
onstrained random manner so that it is at all times ontinuous. In the limit of innite tension, it is the same as the
one fa tor HJM model. In this paper, we show that the introdu tion of this variable removes in onsisten ies between
the one fa tor HJM model and the dynami s of the observed forward rates.

II. REVIEW OF THE ONE FACTOR HJM AND QUANTUM FIELD THEORETIC MODELS

The following is largely taken from Baaquie [4℄.

The one fa tor HJM model models the forward rates as
f (t; x)
t
= (t; x) + (t; x)W (t) (II.1)
where f (t; x) is the instantaneous rate at future time x for a ontra t entered into at time t < x and W (t) is a white
noise pro ess. It is instru tive to note that all the forward rates are driven by the same white noise W (t). For the
purposes of this paper, we assume that the fun tion (t; x) depends only upon the variable  = x t. This is a
theoreti ally reasonable assumption as it is the result of assuming that the theory is time translation invariant. Most
of the fun tions used for (t; x) in the literature satisfy this ondition.
The one fa tor quantum eld theoreti model models the forward rates as
f (t; x)
t
= (t; x) + (t; x)A(t; x) (II.2)
where A(t; x) is a quantum eld whose a tion is given by

1
 Z1 Z t+TFR
S [A℄ = dt dxL[A℄ (II.3)
t0
 A(t; x) 2 !
t

1 1
L[A℄ = 2 A (t; x) + 2
2
x
(II.4)
where TF R is the largest time to maturity for whi h the forward rates are dened (the domain is hen e a semi-innite
parallelogram dened by t < t < t ; t < x < t + TF R ). TF R is introdu ed to ensure that the a tion is well dened
0
but does not ae t nal results as the limit TF R ! 1 is taken as forward rates in prin iple are dened for all future
times. It is also important to take this limit to ensure that the model's e onomy is well dened sin e the e onomy
should be dened on a xed time horizon. An alternative is to x the time horizon for the e onomy and to thus
restri t t < x < T . This is the approa h taken in [4℄. The nal results are independent of either approa h as must
0
be the ase.

t0
(t0 ; t0 ) (t0 ; t0 + TF R )

0 t0 + TF R x
t0 t T
FIG. 1. The Domain for the problem. To a tually perform any al ulation we extend TF R to 1
giving a semi-innite
parallelogram

The initial forward rate urve f (t ; x) has to be spe ied for both models. The eld values of f (t; x) on the rest of
0
the boundary points of the domain are arbitrary and are integration variables. The quantum eld theory is dened
by integrating over all ongurations of f (t; x) (or equivalently A(t; x)) and yields
Z
Z= DAeS[A℄ (II.5)
Z Y Z +1
DA = dA(t; x) (II.6)
(t;x) P 1
where P is the domain of denition of forward rates for the quantum eld theoreti des ription.
Note that eS A / Z is the probability for dierent eld ongurations to o ur when the fun tional integral over
[ ℄

A(t; x) is performed.
The presen e of the se ond term in the a tion given in (II.3) seems to be justied from the phenomenology of the
forward rates [6℄ and is not ruled out by no arbitrage . This term in the a tion also implies that all the random
ongurations of f (t; x) whi h appear in the path integral (II.5) are ontinuous fun tions of x. Forward rates that
are usually observed in the market are ontinuous [10℄.
However the random ongurations for the forward rates are nowhere dierentiable. It is noted in [10℄ that there
is no eviden e to indi ate whether the a tual forward rates are dierentiable or not.
The quantum eld theory is dened by a fun tional integral over all variables A(t; x); the values of A(t; x) on the
boundary of P are arbitrary and are integration variables; this yields the partition fun tion
2
 Z
Z= DAeS[A℄ (II.7)
If we dene
W (t) =
1 Zt +TFR
dxA(t; x) (II.8)
TF R t

then for  ! 0 we have

S [A℄ ! S0 =
1 Z t dtW (t)
2
(II.9)
Z Z 2 t0
DA ! DW (II.10)
whi h is the a tion for Brownian motion. Hen e, in the limit  ! 0, the quantum eld theoreti model redu es to
the HJM model.
Intuitively,  represents the \string tension" of the forward rate urve or the orrelation between the movements of
1

the forward rates of diering maturities. In the HJM model, the movements of the forward rates of all maturities are
perfe tly orrelated (in other words, the string tension is innite). The task of this paper is then to he k whether
this is in fa t the ase, and if so, whether a better des ription is aorded by the quantum eld theoreti model.
The moment generating fun tional for the quantum eld theory is given by the Feynman path integral as
Z R t dt R t+TFR dxJ t;x A t;x
Z [J ℄ =
1 DAe t0 t
(
eS A
) ( ) [ ℄
(II.11)
Z
On performing the al ulation (details are provided in [4℄), we obtain
1 Z t Z TF R
Z [J ℄ = exp dd0 J (t; )D(; 0 ; t; TF R )J (t; 0 ) (II.12)
2 t0 dt 0

where  = x t; 0 = x0 t and the propagator D(; 0 ; t; T ) is given by

TF R h
D(; 0 ; t; TF R ) = 0 0
sinh (TF R ) sinh (TF R ) sinh  f1 + sinh (TF R )(  )g
2
3

+ sinh (TF R 0 ) sinh f1 + sinh (TF R )(0 )g

2

+ osh(TF R )fsinh  sinh 0 i

+ sinh (TF R ) sinh (TF R 0 )g (II.13)
To obtain the above result, we have assumed that the eld A(t; x) is un onstrained at the boundaries. It is, however,
well known that short term interest rates are heavily in uen ed by entral banks. Hen e, it is reasonable to treat the
eld at the boundary where t = x dierently. If we assume that the eld at that boundary is distributed normally
with varian e a, we obtain the propagator
D(0; )D(0; 0 )
D (; 0 ) = D(; 0 ) (II.14)
1
D(0; 0) + a
To understand the signi an e of the propagator D(; 0 ; t; TF R ) note that the orrelator of the eld A(t; ), for
t0 < t; t0 < t < T , is given by
1 Z DAeS A A(t; )A(t0 ; 0 )
E (A(t; )A(t0 ; 0 )) = [ ℄
(II.15)
Z
= Æ(t t0 )D(; 0 ; t; TF R ) (II.16)
In other words, D(; 0 ; t; TF R) is a measure of the ee t of a value of the eld A(t; ) at time to maturity  on its
value at another time to maturity 0 .
We now derive the no-arbitrage ondition for the a tion S [A℄. Sin e the eld A(t; x) generates an innite fa tor
e onomy, no riskless portfolio an be onstru ted if only bonds of dierent maturities are used. Following [5℄, we
assume the existen e of a risk-neutral measure and onsider the evolution of the eld (and hen e the forward rates)
under this measure. Under the risk-neutral measure, the dis ounted bond pri e pro ess must be a martingale.
The relevant domain for the evolution of a zero oupon bond P (t ; T ) from t to t is the trapezoid dened by
0 0
T = (t < t < t ; t < x < T ). This domain is shown in gure II.
0

3
 t

(t ; t )
t
(t ; T )

t0
(t0 ; t0 ) (t0 ; T )

0 T
t0 t x
FIG. 2. The domain for the evolution of a zero oupon bond.

The martingale ondition for the dis ounted bond pri e an be stated as
R t dtf (t;t)
P (t0 ; T ) = Et0 [e t0 P (t ; T )℄ (II.17)
R T f (t;x)dx
Performing the fun tional integrations and noting that P (t; T ) = e t by denition, we see that
Z Z R R
exp (t; x) = 1 DAe T  t;x A t;x e T L A
Z
( ) ( ) [ ℄
(II.18)
T
Z t Z T
= exp 12 dt dxdx0 (t; x)D(x; x0 ; t; TF R )(t; x0 )
t0 t
(II.19)
Hen e we have
Z T
1 ZT
dx(t; x) = 0 0 0
t 2 t dxdx (t; x)D(x; x ; t; TF R )(t; x ) (II.20)
The no arbitrage ondition has to hold for any Treasury bond maturing at any time T . Hen e, we dierentiate
above expression with respe t to T , and obtain
Z x
(t; x) = (t; x) dx0 D(x; x0 ; t; TF R )(t; x0 ) (II.21)
t

In the limit  ! 1, D ! 1. Hen e, we obtain the well known result

Z x
(t; x) = (t; x) dx0 (t; x0 ) (II.22)
t

for the one fa tor HJM model.

From the empiri al study of forward rate urves [6℄ there is eviden e that the risk-neutral HJM-model is not
adequate, sin e no arbitrage implies that the drift term (t; x) is quadrati in the volatility, and whi h is in onsistent
with data; in [6℄ an additional term is added whi h re e ts the term premium. In the ase of eurodollar futures, there
is a small risk of default and the market pri e of redit risk should also be taken into a ount.

4
 III. ANALYSIS OF OBSERVED FORWARD RATES

Following [6℄, we use the daily losing pri es for eurodollar futures pri es as a measure of the forward rates. The
eurodollar futures pri es are linearly interpolated to al ulate the forward rates at 3 month intervals. The 3 month
deposit rate that the eurodollar futures a tually represents is taken to be a good approximation to the instantaneous
forward rate. The data used for this paper are the same as that used in Bou haud [6℄ and were kindly provided by
him. The data over the 1990s and the length of the dataset is 846 trading days and forward rates until 7 years in
the future are available.
We on entrate mainly on the following two quantities (again following Bou haud [6℄)
p
e () = < Æf (t; ) >
2 (III.1)
< Æf (t; min )(Æf (t; ) Æf (t; min )) >
C () = (III.2)
< Æf (t;  ) >
2
min

with the dieren es being taken over one trading day () and min being three months. We assume that there are 250
trading days in a year.
Using the one fa tor HJM model, we an derive the following expressions for the above quantities whi h are a urate
to zeroth order in 
p
e () = ()  (III.3)
()
C () = 1 (III.4)
(min )
q
In deriving this equation, we have dis retized the Brownian motion pro ess W as W (t) =  x where x is a random
1

number with the standard normal distribution. We parti ularly note that the ratio r() = Ce  = (min )p is
( )
( )+1
independent of  () and is in fa t onstant. The ratio as al ulated from the data is shown in gure 3 and an be
seen to be far from onstant. Hen e we see that the time translation invariant one fa tor HJM model is in onsistent
with the real evolution of the FRC for any hoi e of fun tion ().
Ratio
0.0008

0.00075

0.0007

0.00065
r

0.0006

0.00055

0.0005
0 2 4 6 8

theta/year
e ( )
FIG. 3. Plot of C ( )+1 against .

Using the un onstrained quantum eld theoreti model, we an again derive the expressions for the above quantities
to zeroth order a ura y in  to obtain
p
e () = () D(; ; t; TF R ) (III.5)
()D(; min ; t; TF R )
C () = 1 (III.6)
( )D( ;  ; t; T )
min min min FR

5
We have used the dis retization Æ(0) =  where  is the time step for the above derivation.
1

The ratio r() is given in this model by

p
(min ) D(; ; t; TF R )D(min ; min ; t; TF R)
r() = (III.7)
D(; min ; t; TF R )
whi h is still independent of (). However, we note that the ratio is no longer onstant. Using this fa t, we an t the
ratio to nd  and (min ). We took the limit TF R ! 1 as required and used the Levenberg-Marquardt method [11℄
to obtain the non-linear least squares t. We obtained the values  = 0:0822=year and (min ) = 0:0308=year. The
90% onden e interval for (min ) is (0:0299; 0:0317) and that for  is (0:080; 0:085). These intervals were obtained
through the bootstrap method [12℄. An alternative test was done in whi h the data was broken into series of 500 days
starting from the rst day, se ond day and so on and so forth. The fun tion r() was al ulated and the parameters
tted for the resulting 346 data sets. The 90% onden e interval obtained from this approa h was (0:028; 0:033) for
(min ) and (0:081; 0:099) for . The tted ratio together with the observed values are shown in gure III.

Observed and Fitted ratios for the quantum field theoretic model
0.0008

0.00075

0.0007
ratio

0.00065

0.0006

0.00055 Observed ratio

Fitted ratio

0.0005
0 2 4 6 8

theta/year
FIG. 4. The observed and tted r()

Sigma from C and sigmae

0.05

0.045

0.04
sigma*year

0.035

0.03

0.025 Sigma from sigmae

Sigma from C

0.02
0 2 4 6 8

theta/year

6
 FIG. 5.  () derived from e and from C

Sigma from C and sigmae

for HJM
0.016

Sigma from sigmae

Sigma from C

0.014
sigma*year

0.012

0.01

0.008
0 5 10 15 20 25 30

time/quarters
FIG. 6.  () derived from e and from C for the one fa tor HJM model

We an also use equations III.5 and III.6 to obtain two dierent estimates of the fun tion (). These two estimates
are plotted in gure 5. Similar estimates of () for the one fa tor HJM model are plotted in gure 6. As an be
readily seen, the agreement is onsiderably superior for the quantum eld theoreti model.
Performing the same pro edure for the onstrained quantum eld theoreti model, we obtain the t  = 0:0174=year,
(min ) = 0:181=year and a = 0:0024=year. The 90% onden e interval for these parameters found from using
the bootstrap method is (0:158; 0:548) for (min ), (0:006; 0:020) for  and (0:0002; 0:0032) for a. The onden e
interval obtained using the alternative method mentioned above is (0:044; 0:203) for (min ), (0:019; 0:055) for  and
(0:002; 0:071). The tted ratio in this ase is shown in gure 7. The two estimates of () are shown in gure 8. The
agreement between the two fun tions is better than in the ase of the un onstrained model as may be expe ted due
to the additional parameter involved. However, it an be seen from the large onden e intervals that the model is
probably overspe ied sin e dierent values of the parameters give rise to very similar values for r().
Observed and Fitted Ratios
Constrained Boundary Conditions
0.0008

0.00075

0.0007

0.00065

0.0006

0.00055 Observed ratio

Fitted ratio

0.0005
0 2 4 6 8

7
 FIG. 7. The t for r() obtained using the onstrained quantum eld theoreti model

Sigma from C and sigmae

Constrained boundary conditions

Sigma from sigmae

Sigma from C
sigma*year 0.25

0.2

0.15

0.1
0 2 4 6 8

theta/year
FIG. 8.  () derived from e and from C for the onstained quantum eld theoreti model

Another quantity that is of great interest is the mean spread between the forward rates and the spot rate
s() =< f (t; ) f (t; min ) > (III.8)
The spread is made up of two parts : the spread due to the market pri e of risk and the spread that results from the
no arbitrage ondition in the model. Sin e we assume that  is only a fun tion of , it follows that  is also only a
fun tion of . To al ulate the spread due to the model, we assume that the initial forward rate urve is at or that
the ee t of the initial forward rate urve be omes negligible after a long time.
In that ase, the mean spread in the quantum eld theoreti model is given by
Z 
s() = ( min ) tlim
!1 (t) (t)dt (III.9)
min

where
Z t
(t) = (t) ()D(t; ; t; TF R )d (III.10)
0

Using one of the estimates of () (using either gives very similar results), we an al ulate the spread due to the
no arbitrage ondition by numeri al integration. Due to the relative ina ura y of the estimation of () in the rst
pla e, a trapezoidal integration was onsidered suÆ ient. The result together with the observed spread is shown in
gure 9. It is seen that the predi ted spread is signi antly smaller than the a tual spread whi h is onsistent with
the existen e of a term premium. However, we see that a signi ant portion of the spread might be derived from the
way the forward rate urve evolves. A very similar result is obtained when the onstrained quantum eld theoreti
model is used.

8
 Calculated and Observed Spreads
0.03

Calculated spread
0.025 Observed spread

0.02

Spread
0.015

0.01

0.005

0
0 5 10 15 20 25 30

time/quarters
FIG. 9. The al ulated spread and the observed mean spreads

IV. DISCUSSION OF RESULTS

It is not diÆ ult to show that r() in the quantum eld theoreti model is a stri tly non-de reasing fun tion. In fa t,
it an be easily seen that the fun tion has to be non-de reasing in almost any reasonable model as this is equivalent
to stating that the orrelation of the movement of the forward rates of long-term maturity are less orrelated with the
spot rate than the movement of the movement of the short-term maturity forward rates. In the ase of our quantum
eld theoreti model, it is also possible to show that it is a on ave fun tion. We note that the observed r() is stri tly
in reasing but is not on ave. This ould be due to varying string tension at dierent points of the FRC. This is
intuitively reasonable as one expe ts the orrelation of the movement of forward rates 5 years and 5 years 3 months
into the future to be mu h higher than that of the orrelation between forward rates 3 months and 6 months into the
future. Additional work in extending the model to in lude this fa tor is under way.
The proposed method of using a quantity whi h is independent of () would also be useful in onstraining the
hoi e of orrelation stru ture when random elds are used to model the forward rate urve as in [5℄.
It is also seen that a portion of the mean spread an be explained if the quantum eld theoreti model is a urate.
This might be useful to dealers in bonds as it would enable them to hedge away a part of what they normally onsider
the risk premium.

V. SUMMARY AND CONCLUSIONS

We have proposed a way to test the one fa tor, time translation invariant Heath-Jarrow-Morton and Baaquie's one
fa tor, time translation invariant quantum eld theoreti model for the evolution of forward rates using histori al
eurodollar futures data. We nd that the one fa tor HJM model an be reje ted while the quantum eld theoreti
model is still largely onsistent with the data. We also nd that a quantum eld theoreti model with onstrained
boundary onditions to re e t the spe ial nature of the spot rate is also onsistent with the data but the parameters
of the model annot be suÆ iently a urately derived using this method.

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