Interest Rate Modelling I

This chapter reviews a number of interest rate models and the assumptions underlying these models. The key assumption that is made by an interest rate model is whether it is one-factor, that is, the dynamics of the yield change process is based on one factor, or multi-factor. The area of interest rate dynamics and yield curve modelling is one of the most heavily researched in financial economics. Term structure modelling is based on theory describing the behaviour of interest rates. Itô's lemma is used as part of the process of building a term structure model. Many yield curve models are essentially models of the stochastic evolution of the short-term rate. It is straightforward to calculate the present value of any cash flow stream, using the yields observed on a set of risk-free and default-free zero-coupon bonds.