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APPLIED STOCHASTIC MODELS IN BUSINESS AND INDUSTRY
Appl. Stochastic Models Bus. Ind. 2008; 24:359–368
Published online 30 April 2008 in Wiley InterScience (www.interscience.wiley.com). DOI: 10.1002/asmb.718
Factors’ correlation in the Heath–Jarrow–Morton
interest rate model
Leonard Tchuindjo1, 2, ∗, †
1 George
2 Fannie
Washington University, SEAS, 1776 G Street NW, Washington, DC 20052, U.S.A.
Mae, Capital Market Pricing Group, 4000 Wisconsin Avenue NW, Washington, DC 20016, U.S.A.
SUMMARY
We propose a new derivation of the Heath–Jarrow–Morton risk-neutral drift restriction that takes into
account nonzero instantaneous correlations between factors. The result allows avoiding the orthogonalization of factors and provides an approach by which interest rate derivatives can be priced by preserving
the economic meaning of each underlying factor. An application is given for the term structure of creditrisky bonds, driven by two correlated factors—the risk-free forward rate and the forward credit spreads.
Copyright q 2008 John Wiley & Sons, Ltd.
Received 22 June 2007; Revised 4 February 2008; Accepted 25 February 2008
KEY WORDS:
Hilbert space; HJM model; equivalent measure; risk-neutral drift; correlation
1. INTRODUCTION
The Heath–Jarrow–Morton (HJM) [1] approach to the term structure model provides a framework
for pricing interest rate derivative securities. This approach assumes that all factors are orthogonal,
uses the equivalent martingale measure in the pricing procedure, and calibrates the model to the
current yield curve without considering the market price of risk. The market no-arbitrage condition
imposes a relationship, called the risk-neutral drift restriction, between the drift and the volatility
terms. This article contributes to the literature by deriving a risk-neutral drift restriction for the
multi-factor HJM model when there are nonzero instantaneous correlations between factors. A
reformulation of the HJM model in a finite-dimensional Hilbert space prepares a framework for
the integration of an instantaneous correlation matrix between factors.
∗ Correspondence
to: Leonard Tchuindjo, Fannie Mae, Capital Market Pricing Group, 4000 Wisconsin Avenue NW,
Washington, DC 20016, U.S.A.
†
E-mail: [email protected]
Copyright q
2008 John Wiley & Sons, Ltd.
360
L. TCHUINDJO
Keeping the correlations between factors in the HJM model has the appealing feature of
preserving the economic meaning of each factor. Although it is well known that one can always
transform correlated factors into an orthogonal set of factors before deriving the HJM risk-neutral
drift restriction, such orthogonalized factors are mathematical constructs that lack financial meanings. Therefore, in a multiple factor environment, the connection between interest rate derivative
prices and some market observable variables is unclear. For example, following the empirical
studies of Longstaff and Schwartz [2], Duffee [3], Collin-Dufresne et al. [4], and Papageorgiou
and Skinner [5] that find significant negative correlations between the two main factors driving
the prices of corporate bonds, the risk-free interest rate and the credit spread, it is more intuitive
to model the term structure of corporate bonds by these two observable correlated factors than to
use two independent factors, which are the result of orthogonalization and do not have economic
meaning.
In an attempt to address this issue, the risk-neutral drift restriction of a multi-correlated-factor
HJM derived in this paper enables the pricing of interest rate derivatives using easy-to-interpret
factors that can be directly observed on, or implied from, the market. Thereby, the results of this
paper enable one to avoid the use of economically nonintuitive factors, which is what often results
when correlated factors are orthogonalized. These results are applied to the forward rate dynamics
of the term structure of credit-risky bonds driven by two observable correlated factors—the risk-free
forward rate and the forward default intensity—to obtain an extra risk-neutral drift term.
The remainder of this paper is organized as follows. Section 2 reformulates the HJM model in
a finite-dimensional Hilbert space. In Section 3, a more general HJM risk-neutral drift restriction,
which takes correlation between factors, is derived. Section 4 is an application that derives an
extra drift term for the term structure of credit-risky bonds, using an intensity based reduced-form
approach. Section 5 is a numerical illustration.
2. THE HJM MODEL IN A FINITE-DIMENSIONAL HILBERT SPACE
Hereafter, all random variables and stochastic processes are defined on a filtered probability space
(, FT , (Ft )(t 0) , P), where
1. is the set of all possible states of nature.
2. T <∞ is a fixed time horizon.
3. (Ft )(t 0) is the filtration representing the information structure, and it satisfies the usual
conditions of Jacod and Shiryaev [6].
4. P is the physical measure associated with objective probabilities.
Further, we define Hn to be the vector space of real column vectors of nonzero dimension n ∈ N.
We equip Hn with a real inner product ·, · : Hn ×Hn → R, defined by A, B = AT B, for all
A, B ∈ Hn , such that Hn becomes a pre-Hilbert space. More specifically, Hn is isometric to Rn .
Hence, Hn is an n-dimensional Hilbert space.
Let { f (t, T, t )}(0t T ) be the stochastic process of the instantaneous forward rate at time t
for a maturity date T t. For a given nonnegative finite T , let the stochastic differential equation
of f be given by
d f (t, T, t ) = (t, T, t ) dt +V(t, T, t ), dZ(t, t )
Copyright q
2008 John Wiley & Sons, Ltd.
(1)
Appl. Stochastic Models Bus. Ind. 2008; 24:359–368
DOI: 10.1002/asmb
HEATH–JARROW–MORTON INTEREST RATE MODEL
361
where
1. {Z(t, t )}(t 0) = [{z 1 (t, t )}(t 0) , {z 2 (t, t )}(t 0) , . . . , {z n (t, t )}(t 0) ]T is a vector of n independent P-standard Brownian motions and represents the path of these processes.
2. (t, T, t ) : {(t, T ) : 0tT <∞}× → R is the drift, which is P-almost everywhere absolutely integrable on any finite time horizon.
3. V(·, T, ·) is such that V(t, T, t ) = [v1 (t, T, t ), v2 (t, T, t ), . . . , vn (t, T, t )]T belongs to S,
the set of all functions defined from {(t, T ) : 0tT <∞}× onto Rn , that are P-almost
everywhere nonnegative, bounded, square integrable on any finite time horizon, and Lipschitz
continuous with respect to the second variable.
According to Heath et al. [1], the absence of arbitrage implies that there exists a unique
measure Q, equivalent to P, as in the standard pricing theory of Harrison and Kreps [7], and
Harrison and Pliska [8], under which the stochastic differential equation of the forward rate is
given by
T
d f (t, T, t ) = V(t, T, t ),
V(t, s, t ) ds dt +V(t, T, t ), dW(t, t )
(2)
t
where {W(t, t )}(t 0) = [{w1 (t, t )}(t 0) , {w2 (t, t )}(t 0) , . . . , {wn (t, t )}(t 0) ]T is a vector of n
independent Q-standard Brownian motions. The following equation
T
(t, T, t ) = V(t, T, t ),
V(t, s, t ) ds , (Q—a.e.)
(3)
t
is called the risk-neutral drift restriction. It shows that the drift term is well defined whenever the
volatility term is given. As a result, the HJM model is completely specified if the volatility process
is specified.
Many studies have focused on the different classes of models that arise when different assumptions about the form of the volatility process are made (see, e.g. Ritchken and Sankarasubramanian
[9] and Chiarella and Kwon [10]); but studies on the correlation between factors that can drive the
forward rate process have been limited. In the following section, a more general form of the drift
term is presented for the case where the Brownian motions driving the forward rate dynamics are
correlated. Hereafter, for simplicity of notation, the argument t representing the path dependence
of the process will be omitted.
3. THE HJM MODEL WITH CORRELATED FACTORS
The main assumption of this section is that all factors can be correlated. Hence, the aim is to
derive a more general drift restriction under the equivalent measure Q, such that the original HJM
result becomes a particular case. Now let
{Z̃(t)}(t 0) = [{z̃ 1 (t)}(t 0) , {z̃ 2 (t)}(t 0) , . . . , {z̃ n (t)}(t 0) ]T
(4)
be a vector of n correlated (Ft )(t 0) -adapted standard Brownian motions on (, FT , P) such
that, almost everywhere with respect to the physical probability measure P and the sigma algebra
Ft , we have
dZ̃(t) dZ̃T (t) = K(t) dt
Copyright q
2008 John Wiley & Sons, Ltd.
(P—a.e.)
(5)
Appl. Stochastic Models Bus. Ind. 2008; 24:359–368
DOI: 10.1002/asmb
362
L. TCHUINDJO
where K(t) is the n ×n correlation coefficient matrix of {Z̃(t)}(t 0) at time t0. It is defined as
K(t) = [ki, j (t)](i, j=1,2,...,n) , such that −1ki, j (t) = k j,i (t)1 and ki,i (t) = 1.
Let {C(t)}(t 0) = [{1 (t)}(t 0) , {2 (t)}(t 0) , . . . , {n (t)}(t 0) ]T be a vector of n processes that are
(Ft )(t 0) -predictable processes and satisfy Novikov’s condition. Then the process {m(t)}(t 0) ,
t
t
defined by m(t) = exp( 0 C(s), dZ(s)−( 12 ) 0 C(s), C(s) ds) is a P-martingale, and hence, for
0t<∞ we have E P [m(t)] = E P [m(0)] = 1, where E P (·) is the expectation with respect to the
physical probability measure P.
A new probability measure Q, equivalent to P, can be defined on FT , such that ∀A ∈ FT
we have Q(A) = E Q [1{A} ] = E P [1{A} m(T )], where 1{A} is the indicator function of the even A.
m(T ) = dQ/dP |FT is the Radon–Nikodym derivative, at time T , of the measure Q with respect
to the measure P. In what follows, we use the fact that this change of measure to an equivalent
one preserves the correlation structure between standard Brownian motions (see, e.g. Brigo and
Mercurio [11, p. 33]) to generalize the HJM risk-neutral drift restriction.
Theorem 3.1
If the stochastic differential equation of the forward rate dynamics is given by
d f (t, T ) = (t, T ) dt +V(t, T ), dZ̃(t)
(6)
where (t, T ) and V(t, T ) are defined similar to those in Equation (1), and {Z̃(t)}(t 0) is defined
T
by Equations (4) and (5), then d f (t, T ) = V(t, T ), K(t) t V(t, s) ds dt +V(t, T ), dW̃(t), where
{W̃(t)}(t 0) is a n-dimensional vector of correlated Q-standard Brownian motions with correlation
matrix K(t).
Proof
See Appendix.
Theorem 3.1 leads to an adjusted risk-neutral drift restriction given by
T
(t, T ) = V(t, T ), K(t)
V(t, s) ds
(7)
t
Clearly Equation (7) shows that in addition to the components of a regular HJM risk-neutral drift,
there are components coming from each pair of correlated factors. The following section illustrates
these additional terms in the case of the term structure of credit-risky bonds.
4. AN APPLICATION TO THE TERM STRUCTURE OF DEFAULTABLE BONDS
Using the intensity-based reduced-form approach, we derive in this section an extra risk-neutral
drift term of the forward rate dynamics of the term structure of credit-risky bonds driven by two
correlated factors—the risk-free forward rate and the forward default intensity.
Theorem 4.1
The instantaneous credit-risky forward rate, f˜(t, T ), can be modeled as the sum of the corresponding instantaneous default-free forward rate and forward credit spread. i.e. for any finite time t
such that 0tT , almost everywhere (w.r.t. Q) we have f˜(t, T ) = f (t, T )+h(t, T ), where h(t, T )
is the instantaneous forward credit spread for the maturity date T , as seen at time t.
Copyright q
2008 John Wiley & Sons, Ltd.
Appl. Stochastic Models Bus. Ind. 2008; 24:359–368
DOI: 10.1002/asmb
363
HEATH–JARROW–MORTON INTEREST RATE MODEL
Proof
See, e.g. Schonbucher [12, pp. 206–211].
Theorem 4.1 specifies the stochastic dynamics of the credit-risky forward rate in such a way that
the correlation between default-free forward rate and the forward credit spread can be explicitly
shown in a closed-form solution. We can define the dynamics of the default-free forward rate and
the forward credit spread as
d f (t, T ) = f (t, T ) dt + f (t, T ) dw̃ f (t)
(8)
where f (t, T ) is a time-dependent drift, w̃ f (t) is a Q-standard Brownian motions, and f (t, T )
is the volatility of the forward rate; and
dh(t, T ) = h (t, T ) dt +h (t, T ) dw̃h (t)
(9)
where h (t, T ) is a time-dependent drift, w̃h (t) is a Q-standard Brownian motion, and h (t, T ) is
the volatility of the forward credit spread.
Using Theorem 4.1, Equations (8) and (9), the credit-risky forward rate dynamics is given by
d f˜(t, T ) = (t, T ) dt + f (t, T ) dw̃ f (t)+h (t, T ) dw̃h (t)
(10)
where (t, T ) = f (t, T )+h (t, T ).
According to the standard HJM risk-neutral drift restriction, if w̃ f (t) and w̃h (t) are independent,
the absence of arbitrage will impose the drift term of Equation (10) to be given by
(t, T ) = f (t, T )
T
f (t, s) ds +h (t, T )
t
T
h (t, s) ds
(Q—a.e.)
(11)
t
It should be noticed that the standard HJM risk-neutral drift restriction does not take into account
the correlations between factors. As the change of measure to an equivalent one preserves the
correlation structure between standard Brownian motions, if there is a nonzero correlation, between
the forward interest rate process and the forward credit spread process under the real-world probability measure, the two processes will have the same correlation under the equivalent martingale
measure. Further, if k f,h (t) is the correlation coefficient at time t between the forward risk-free
rate and forward credit spread, by Equation (7) the no-arbitrage condition implies that under the
equivalent martingale measure
(t, T ) = f (t, T )
T
T
f (t, s) ds +h (t, T )
t
h (t, s) ds
t
+ k f,h (t) f (t, T )
t
T
h (t, s) ds +h (t, T )
T
f (t, s) ds
(Q—a.e.)
(12)
t
As a result, an extra term is added to the risk-neutral drift, and that term becomes bigger as the
correlation coefficient is closer to 1 in absolute value. As both the volatilities of the risk-free rate
and the credit spread are positive numbers, a positive (negative) correlation increases (decreases)
the risk-neutral drift term.
Copyright q
2008 John Wiley & Sons, Ltd.
Appl. Stochastic Models Bus. Ind. 2008; 24:359–368
DOI: 10.1002/asmb
364
L. TCHUINDJO
5. NUMERICAL APPLICATIONS
In this subsection, we use Monte Carlo simulation to forecast the evolution (from January 1,
2007 to January 31, 2007) of the 2-month tenor forward U.S. Dollar Libor rate maturing on
January 31, 2008 (i.e. effective from January 31 to March 31, 2008). Only U.S. business days are
considered in this application, and 1-month and 1-year periods have 21 and 252 business days,
respectively.
5.1. Description of data
The U.S. Dollar Libor rate is higher than risk-free rate, as it takes into account the credit risk of
the banking system. In this analysis, we first consider the yield of the U.S. Treasury Bill to be a
good proxy for the risk-free rate. Then we use Theorem 4.1 to represent the 2-month tenor forward
Libor as the sum of the 2-month tenor forward risk-free rate and the 2-month tenor forward credit
spread. All data points are obtained from BloombergTM where the tickers of the U.S. Dollar Libor
rate and the U.S. Treasury Bill rate are US00 and USGG, respectively:
• We derived the 2-month tenor forward Libor from the daily values of the 1-month and 3-month
U.S. Dollar Libor rates for the last half of 2007 (i.e. from July 2, 2007 through December
28, 2007).
• We derived the 2-month tenor forward risk-free rate from the daily values of the 1-month and
3-month U.S. Treasury bill rates for same period.
• Then the 2-month tenor forward credit spread is the difference in the two preceding rates.
5.2. Computational approaches
The correlated HJM approach: Using the above data we compute the annualized historical volatilities of the series of both the 2-month tenor forward risk-free rate and the 2-month tenor forward
credit spread. Their values are 11.4041 and 9.5781%, respectively. The historical correlation coefficient of these two series is negative 95.7741% for this period. Then we use the volatilities, the
correlation, and the initial value (4.7775% as of December 28, 2007) of the 2-month tenor forward
U.S. Dollar Libor rate maturing on January 31, 2008 to simulate its daily path till maturity, as
explained in Equations (10) and (12).
The standard HJM approach: In conjunction with the above two series, we use the principal
component analysis to create two orthogonal series. These two new series have the annualized
volatilities of 14.794 and 2.1316%, respectively. Then we use these volatilities, Equations (10)
and (11), and the initial value of the 2-month tenor forward U.S. Dollar Libor rate maturing on
January 31, 2008 to simulate its daily path till its maturity.
5.3. Results and discussion
Table I presents the results, in percentage, of the forecast of the evolution of the 2-month tenor
forward U.S. Dollar Libor rate. The first column shows the business day for which the forecasts
are done. The second and third columns are the forecast results by the correlated and the standard
HJM approaches, respectively. The last column is the difference in the two forecast results.
The forecast results by the two different approaches are very close. The average and the maximum
difference over the forecasting period are 0.36 and 2.43 basis points, respectively (a basis point
is 10−4 ). The mean square difference of the two forecasts is 2×10−8 . However, the annualized
Copyright q
2008 John Wiley & Sons, Ltd.
Appl. Stochastic Models Bus. Ind. 2008; 24:359–368
DOI: 10.1002/asmb
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HEATH–JARROW–MORTON INTEREST RATE MODEL
Table I. Forecast results in percentage.
U.S. Business day
January
January
January
January
January
January
January
January
January
January
January
January
January
January
January
January
January
January
January
January
January
02,
03,
04,
07,
08,
09,
10,
11,
14,
15,
16,
17,
18,
22,
23,
24,
25,
28,
29,
30,
31,
Correlated HJM
Standard HJM
4.7724
4.7712
4.7721
4.7723
4.7670
4.7774
4.7741
4.7724
4.7799
4.7831
4.7812
4.7889
4.7901
4.7930
4.8022
4.8029
4.8048
4.8031
4.7936
4.7925
4.7931
4.7945
4.7688
4.7733
4.7931
4.7452
4.7904
4.7721
4.7687
4.7688
4.7591
4.7772
4.8132
4.8130
4.7961
4.8232
4.8258
4.8203
4.8083
4.7867
4.7703
4.7951
2008
2008
2008
2008
2008
2008
2008
2008
2008
2008
2008
2008
2008
2008
2008
2008
2008
2008
2008
2008
2008
Difference
−0.0221
0.0024
−0.0012
−0.0209
0.0217
−0.0131
0.0020
0.0038
0.0111
0.0240
0.0040
−0.0243
−0.0229
−0.0031
−0.0210
−0.0229
−0.0155
−0.0053
0.0069
0.0223
−0.0020
volatility of the forecasted result by the correlated HJM is less than the one of the forecast resulted
by the standard HJM: 19.51 versus 35.92%. In regard to this application, this feature allows the
correlated HJM approach to be more appropriate for the pricing purpose.
APPENDIX A: PROOF OF THEOREM 3.1
Equation (6) can be rewritten in stochastic integral form as
f (t, T ) = f (0, T )+
t
(s, T ) ds +
0
t
V(s, T ), dZ̃(s)
(A1)
0
Let B(t, T ) be the price at time t of a zero-coupon bond that matures at time T . We have
B(t, T ) = exp −
T
f (t, s) ds
(A2)
t
By Leibnitz’s rule of differentiation, the previous equation becomes
d ln B(t, T ) = f (t, t)−
T
t
Copyright q
2008 John Wiley & Sons, Ltd.
T
*
d f (t, s) ds
f (t, s) ds dt = f (t, t) dt −
*t
t
(A3)
Appl. Stochastic Models Bus. Ind. 2008; 24:359–368
DOI: 10.1002/asmb
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L. TCHUINDJO
Substituting f (t, t) from Equation (A1) and d f (t, s) from Equation (6) into Equation (A3), we
obtain
t
t
d ln B(t, T ) = f (0, t) dt +
(s, t) ds dt +
V(s, t), dZ̃(s) dt
0
−
T
0
(t, s) dt ds −
t
T
t
= f (0, t)+
(s, t) ds +
0
T
−
V(t, s), dZ̃(t) ds
t
t
V(s, t), dZ̃(s)−
0
T
(t, s) ds dt
t
V(t, s) ds, dZ̃(t)
(A4)
t
Applying Ito’s lemma to the preceding equation, the stochastic differential equation of the
zero-coupon bond price can be expressed as
t
t
T
dB(t, T )/B(t, T ) = f (0, t)+
(s, t) ds +
V(s, t), dZ̃(s)−
(t, s) ds dt
0
t
T
2
1
V(t, s) ds, dZ̃(t) +
V(t, s) ds, dZ̃(t)
2
t
T
−
0
t
(A5)
T
As t V(t, s) ds, dZ̃(t) is a scalar and ·, · is a symmetric form on Hn , we have
2
T
T
=
V(t, s) ds, dZ̃(t)
t
T
V (t, s) ds dZ̃(t) dZ̃ (t)
T
t
=
V(t, s) ds
t
T
T
T
V (t, s) ds [dZ̃(t)dZ̃ (t)]
T
T
t
V(t, s) ds
t
Using Equation (5), the preceding equation becomes
2
T
=
V(t, s) ds, dZ̃(t)
t
T
V(t, s) ds, K(t)
t
T
V(t, s) ds dt
(A6)
t
Hence, Equation (A5) can be rewritten as
t
t
dB(t, T )/B(t, T ) = f (0, t)+
(s, t) ds +
V(t, s), dZ̃(s)
0
T
−
t
−
1
(t, s) ds +
2
0
T
V(t, s) ds, K(t)
t
T
V(t, s) ds, dZ̃(t)
T
V(t, s) ds
dt
t
(A7)
t
Copyright q
2008 John Wiley & Sons, Ltd.
Appl. Stochastic Models Bus. Ind. 2008; 24:359–368
DOI: 10.1002/asmb
367
HEATH–JARROW–MORTON INTEREST RATE MODEL
We can define a nonlinear operator, D, on S such that ∀V(·, ·) ∈ S,
T
t
t
(s, t) ds −
(t, s) ds +
V(s, t), dZ̃(s)
D[V(t, T )] = f (0, t)+
+
1
2
0
t
T
V(t, s) ds, K(t)
t
T
0
V(t, s) ds
(A8)
t
By the Hilbert space representation theorem, we can find an n-dimensional bounded (Ft )(t 0) predictable process, {U(t)}(t 0) , such that
T
V(t, s) ds, U(t)
(A9)
D[V(t, T )] =
t
Equations (A8) and (A9) imply that
T
t
V(t, s) ds, U(t) = f (0, t)+
(s, t) ds −
t
1
+
2
0
T
(t, s) ds +
t
T
V(t, s) ds, K(t)
t
T
t
V(s, t), dZ̃(s)
0
V(t, s) ds
(A10)
t
For every time t0, the vector U(t) = [1 (t), 2 (t), . . . , n (t)]T will provide a proportional
relationship between the drift rate of change of prices and the amount of risk in price changes
stemming from each Brownian motion. U(t) can be viewed as the n-dimensional market price of
risk at time t. Provided that U(t) satisfies Novikov’s condition, the process {W̃(t)}(t 0) defined by
dW̃(t) = dZ̃(t)−U(t) dt
(A11)
is an n-dimensional vector of correlated Q-standard Brownian motions, having K(t) as their
correlation matrix.
By differentiating both sides of Equation (A10), with respect to T , we obtain
T
(t, T ) = V(t, T ), K(t)
V(t, s) ds −V(t, T ), U(t)
(A12)
t
Substituting Equation (A12) into Equation (6), the forward rate dynamics under the new equivalent
probability measure Q is given by the following equation:
T
d f (t, T ) = V(t, T ), K(t)
V(t, s) ds +V(t, T ), U(t) dt −V(t, T ), dZ̃(t)
t
As ·, · is a bilinear form on Hn , the preceding equation becomes
T
d f (t, T ) = V(t, T ), K(t)
V(t, s) ds dt +V(t, T ), [dZ̃(t)−U(t) dt]
t
Using Equation (A11), the preceding equation becomes
T
d f (t, T ) = V(t, T ), K(t)
V(t, s) ds dt +V(t, T ), dW̃(t)
t
Copyright q
2008 John Wiley & Sons, Ltd.
Appl. Stochastic Models Bus. Ind. 2008; 24:359–368
DOI: 10.1002/asmb
368
L. TCHUINDJO
ACKNOWLEDGEMENTS
The author would like to thank the editor and an anonymous referee for their suggestions which helped
in improving the original version of this paper.
REFERENCES
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DOI: 10.1002/asmb
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