Page 26 - FINAL CFA II SLIDES JUNE 2019 DAY 9

LOS 34.k: Describe modern term structure READING 34: THE TERM STRUCTURE AND
models and how they are used. INTEREST RATE DYNAMICS
MODULE 34.6: INTEREST RATE MODELS
Other Advantages of Ho Lee Model:

• The ability to calibrate this model to match current market
prices is their main advantage over the equilibrium models. Disadvantages:

• Because it generates a symmetrical (“bell-shaped”
• It can be used to determine zero-coupon bond prices and the
spot curve. or normal) distribution of future rates, negative
interest rates are possible.
• By construction, the output is consistent with market prices.

• Because of its simplicity, it useful for illustrating most of the
salient features of arbitrage-free interest rate models.

Overall conclusion on these models?

We often need to value bonds with embedded options and the values of these embedded options are frequently contingent on
interest rates, so we need these modern interest rate theories for the most part to value bonds these bonds.

• The general equilibrium models describe yield curve movement as the movement in a single short-term rate. They are called
one-factor models and, in general, seem empirically satisfactory.

• Arbitrage-free models do not attempt to explain the observed yield curve. Instead, these models take the yield curve as given.
For this reason, they are sometimes labeled as partial equilibrium models.