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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
MODERN TERM STRUCTURE MODELS
Attempt to capture the statistical properties of interest rates movements and provide us with quantitatively precise descriptions of
how interest rates will change.
Equilibrium Term Structure Models:
These describe changes in the term structure through the use of fundamental economic variables that drive interest rates.
These can be single or multifactor models: most notably, Cox-Ingersoll-Ross (CIR) model and the Vasicek Model, are both
single-factor models.
The Cox-Ingersoll-Ross Model -Interest rate movements are driven by individuals choosing between consumption today
versus investing and consuming at a later time.
Random component:
Drift term: forces the Volatility increases with
interest rate to the interest rate.
mean-revert toward
the long-run value In other words, at high
(b) at a speed interest rates, the
determined by the amount of period-over-
mean reversion period fluctuation in
parameter (a). rates is also high.
