I'm trying to understand which parameter controls the instantaneous correlation in the 2 F HW model. As in, correlation b/w 2 rates observed at the same time. My thinking is as follows:

$$Rate(1)=P(t,x(t),y(t))$$ $$Rate(2)=Q(t,x(t),y(t))$$

Intuitively, if I know $Rate(1)$, more the correlation between short rates $x(t)$ and $y(t)$, the better I can predict $Rate(2)$, and thus correlation must be controlled by the correlation between the Brownian Motions.

However, correlation must also depend on the mean reversion difference, because we're back to perfect correlation (1F HW) if mean reversions of the 2 short rates are the same.

I am wondering if someone has the closed form expression for this correlation. I'd be very glad to see a reference.

For reference above, $P$ and $Q$ are some functions, $x(t)$ and $y(t)$ are the 2 constituent short rates in the model.

Edit: To clarify, I'm asking for the correlation between 2 rates in the same currenct, but of different tenors (say 3M LIBOR and 6M LIBOR)

  • $\begingroup$ Two-factor HW is a model with two stochastic drivers for a single short rate process. It sounds like you are asking for the correlation between two short rates (eg. one for EUR and one for USD)? This will involve four stochastic drivers (two factors per short rate) which will in general have a correlation matrix with 6 off-diagonal terms - is this what you are asking about, or have I misunderstood? $\endgroup$ – StackG Aug 5 at 4:22
  • $\begingroup$ I'm asking about the correlation b/w say the 3M Libor and the 6 M Libor (different tenors). $\endgroup$ – Arshdeep Singh Duggal Aug 5 at 4:32
  • $\begingroup$ Ok, that makes more sense - so in the ideal case, the 3M rate and the 6M rate are both calculated from $- {\frac {\partial} {\partial T}} \ln{P(0,T)}$ where $P(0,T)$ is the ZCB out to that tenor coming from the integrated short rate - you want the autocorrelation of this? $\endgroup$ – StackG Aug 5 at 4:49
  • $\begingroup$ You want correlation of forward-starting libor? I'm pretty sure you do not. I think your $t$ should be $0$, so you exactly want the correlation of the now-to-3M and now-to-6M rate? $\endgroup$ – StackG Aug 5 at 4:59
  • $\begingroup$ Ok without getting too entangled in the terminology, sure you can tell me the correlation of the t=0 case I'd be happy (although strictly speaking I already know these rates, they're not random variables anymore) - but the mechanics of the exercise should be exactly the same if you treat them as random. $\endgroup$ – Arshdeep Singh Duggal Aug 5 at 5:03

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