Models for the Interest Rate and Interest Rate Derivatives

Abstract

Pricing interest rate derivatives fundamentally depends on the underlying term structure. The often made assumptions of constant risk free interest rate and its independence of equity prices will not be reasonable when considering interest rate derivatives. Just as the dynamics of a stock price are modeled via a stochastic process, the term structure of interest rates is modeled stochastically. As interest rate derivatives have become increasingly popular, especially among institutional investors, the standard models for the term structure have become a core part of financial engineering. It is therefore important to practice the basic tools of pricing interest rate derivatives. For interest rate dynamics, there are one-factor and two-factor short rate models, the Heath Jarrow Morton framework and the LIBOR Market Model.