Multi-Factor HJM models

In this section, we start from a simple multi-factor HJM term structure model and derive the drift term of the forward rate dynamics required to obtain an arbitrage-free model framework (see HJM [35]). Furthermore, we derive the equivalence between the HJM-framework and a corresponding extended short rate model. Then, by applying our option pricing technique (see chapter (2)) we are able derive the well known closed-form solution for the price of an option on a discount bond (e.g. caplet or floorlet).