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I refer to MFM introduced by Hunt [2000]. These models can be seen a subset of interest rate market models. MFM allow us to describe the term structure elements using a set a functions of a low-dimensional Markov process (say 1 or 2).

This gives to the model the ability to calibrate fairly well and to capture the smile. Of course, due to limited number of risk factors can fail to capture the instantaneous correlation structures between rates. However, being low-dimensional, Markovian and relatively good with the smile it did not make it so popular yet.

If indeed this is true. What do you see as the reason? Why do people still prefer short rate modelling (maybe with stochastic vol) or even the path-dependent BGM?

Thank you in advance.

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    $\begingroup$ Cross-posted on Nuclear Phynance. $\endgroup$ Commented Jan 10, 2015 at 20:31
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    $\begingroup$ Would you like to post the full title of the reference or even tex some formula as an a example? This would be helpful to me. $\endgroup$
    – Richi Wa
    Commented Jan 13, 2015 at 12:22
  • $\begingroup$ Markov-Functional Interest Rate Models $\endgroup$ Commented Jan 14, 2015 at 10:57
  • $\begingroup$ papers.ssrn.com/sol3/papers.cfm?abstract_id=49240 $\endgroup$ Commented Jan 14, 2015 at 10:58

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it's difficult to say that they are not popular. Some people definitely use them for live pricing. I'd say the real question is "why are they not popular in the academic literature"?

One answer would simply be that most the questions that arise in their use are ones of fiddliness which do not make good papers.

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In context of Bermudan Options, I believe that since the model determines everything exogenously, calibrating to swaptions may give you cases where the implied forward rate is negatively correlated to swap rates. Note this will never happen in an endogenous model where the short rate equation constrains this possibility.

This will obviously distort exercise boundaries, as roughly, swap rate is a linear combination of forwards, and thus the implied correlation between swap rates may be completely unrealistic. Simply put, the model recovers marginals but lack of endogenous structure makes it difficult to control the joint distributions.

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The Markov-functional model is widely used by dealers around the Street in particular for Bermudan swaptions. So we cannot say it is not popular. Of course, there has been some criticisms since its birth. But somehow it seems that the Bermduan swaption market does not collapse (at least not yet) due to use of the MF model (maybe because the model does not matter that much for an one-way market like the Berm market).

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