Analysing and Interpreting the Yield Curve, 2nd Edition

CHAPTER 3Interest Rate Modelling I: Primer on Basic Concepts

Following the introduction in Part I we are now in a position to move to fundamental questions of the yield curve, the processes that determine the evolution of the interest rate term structure, and how these processes can be modelled. The chapters in Part II review a number of interest rate models and the assumptions underlying these models. We also look at the procedure involved in estimating and fitting the yield curve. This topic is one of the most heavily researched subjects in financial market economics, and indeed research is ongoing. There are a number of ways to estimate and fit the yield curve, and there is no one right or wrong method. It is all a matter of finding the approach of best fit (pun intended!).

It is important when discussing this subject to remember to place the relevant ideas in context, otherwise there is a danger of becoming too theoretical. The aim is to confine the discussion within the boundary of user application, as there is a great deal of published material that is, quite simply, rather too academic. We must always try to keep in touch with the markets themselves. These chapters are written from the point of view of the market practitioner. We emphasise that this is a book about the bond markets, rather than a mathematics textbook. There are very few derivations, and fewer (if any) proofs. (This material is covered abundantly in existing literature.)

In the following chapters, we summarise ...