Some Remarks on Modeling the Term Structure of Interest Rates

Abstract

Marti Subrahmanyam [1996] provides an excellent review of models that deal with the dynamics of the term structure of interest rates. Most of this work has been accomplished in the last twenty years, partly stimulated by academic interest to apply the Black-Scholes framework to the pricing of interest-rate options but also by practitioners’ needs to manage interest-rate risks. In the following, I shall first put the theoretical work on the term structure into the broader perspective of capital market research in order to highlight some important differences between valuation of stocks and of bonds. Second, I shall address some specific issues in modeling the term structure to reveal potential deficiencies of the current state of the art. Third, I shall discuss some implications for financial risk management.