Chapter31 Interest Rate Derivatives: Models of the Short Rate

The models for pricing interest rate options that we have presented so far make the assumption that the probability distribution of an interest rate, a bond price, or some other variable at a future point in time is lognormal. They are widely used for valuing instruments such as caps, European bond options, and European swap options. However, they have limitations. They do not provide a description of how interest rates evolve through time. Consequently, they cannot be used for valuing interest rate derivatives that are American-style or structured notes.

This chapter and the next discuss alternative approaches for overcoming these limitations. These involve building what is ...

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