PT - JOURNAL ARTICLE AU - Jeroen Kerkhof AU - Antoon Pelsser TI - Observational Equivalence of Discrete String Models and Market Models AID - 10.3905/jod.2002.319190 DP - 2002 Aug 31 TA - The Journal of Derivatives PG - 55--61 VI - 10 IP - 1 4099 - https://pm-research.com/content/10/1/55.short 4100 - https://pm-research.com/content/10/1/55.full AB - One of the newest ideas in describing interest rate behavior is the “discrete string” model of the term structure. In a string model, forward rates are functions of an arbitrarily large number of underlying stochastic processes, and are tied together by a correlation matrix that depends on the factors in such a way that the overall system is arbitrage-free. The widely used LIBOR market model also models the behavior of a set of forward rates and obtains a correlation matrix for them in an arbitrage-free framework. Although the theoretical underpinnings of the two approaches are quite different, they are similar on a practical basis, because both are based on observed forward rates in the market. In this article, Kerkhof and Pelsser clarify the connection between the two approaches and show that they are “observationally equivalent” in the sense that, given a set of observed forward rates and assuming the same number of stochastic factors, the two models will produce identical valuations for interest-dependent instruments. A numerical example illustrates the computations involved.