In late 1980s David Heath, Robert Jarrow and Andrew Morton worked on interest rate framework which would unify the theory for valuing contingent claims under a stochastic term structure of interest rates. The paper, *Bond pricing and the term structure of interest rates: A new methodology for contingent claims valuation*, was published in 1992 in Econometrica.

In this post we will quickly describe the model and derive the no-arbitrage condition in the risk-neutral measure in a single economy.

## Definitions and Relationships

Let $f(t,T)$ be a *nominal instantaneous forward rate* at time with expiry , be a *nominal zero coupon bond price* at time with maturity . The relationship between the two is

where is the ending point in the trading interval. The *nominal spot rate* at time , , is the nominal instantaneous forward rate at time for date

The *risk-free nominal money-market account* (accumulation factor), initialized at time 0 with a one unit of currency investment is

## No-Arbitrage Conditions

Under the nominal risk neutral measure the dynamics of the nominal risk-free zero coupon bond is

where is a -dimensional standard -Brownian motion. Assuming following dynamics for the , the question now is to identify the drift term

Let , then

Next, by applying standard and stochastic Fubini theorem we get

where and . We are almost there, now we can put all things together and using the very first equation and Ito’s lemma

Please note that under the risk-neutral measure the drift term for must be equal to . We conclude following no-arbitrage condition which must hold for all

By differentiating both sides with respect to we obtain

So the final stochastic differential equation for the instantaneous forward rate under the risk-free measure is of the following form