Encyclopedia of Financial Models, 3 Volume Set

The Dynamic Term Structure Model

DAVID AUDLEY, PhD

Senior Lecturer, The Johns Hopkins University

RICHARD CHIN

Investment Manager, New York Life Investments

PETER C. L. LIN

PhD Candidate, The Johns Hopkins University

SHRIKANT RAMAMURTHY

Consultant, New York, NY

Abstract: The term structure of interest rates represents the cost of (return from) borrowing (lending/investing) for different terms at any one moment in time. The term structure is most often specified for a specific market such as the U.S. Treasury market, the bond market for double A rate financial institutions, the interest rate market for LIBOR and swaps, and so on. The term structure is usually specified via a rate or yield for a given term or the discount to a cash payment at some time in the future. These are often summarized mathematically through a wide variety of models. In addition, term structure models are fundamental to expressing value, risk, and establishing relative value across the spectrum of instruments found in the various interest-rate or bond markets. Dynamic models of the term structure are characterizations that are specifically established to consider future market scenarios where there is uncertainty. As such they are rooted in probability, stochastic process, and martingale theory. Standard models include those derived from assumptions that include a short-rate or a forward rate process as an explanatory factor for the evolution of markets. Instantiations of these models include a general ...