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Interest Rate Simulation Crash Course

Interest Rate Simulation Crash Course

Interest rates tend to fluctuate on a day-to-day basis as well as occasionally when there is a regime shift. These changes may signify a significant risk to those portfolios and instruments whose values are derived from movements in the interest rate.

Interest rate models are usually employed in order to value instruments. The purpose of these models is to understand interest rate behavior. With a better understanding of how interest rates behave, the risk manager is better able to discern interest rate movements, determine the likely range of future values and estimate the probabilities of losing more that a given amount. Understanding the movements helps in setting acceptable limits; economic policy; valuing financial instruments more reliably or hedging them more effectively.


Topics covered:

  1. Components of interest rate models
  2. Features of good models
  3. Criteria employed when selecting models
  4. Differences between various types of term structure models such as equilibrium and no-arbitrage models and one-factor and multifactor models
  5. Estimation and calibration of parameters for, and construction of, the one-factor equilibrium Cox-Ingersoll-Ross (CIR) model,
  6. Construction and utilization of the one-factor no-arbitrage Black-Derman-Toy (BDT) model
  7. Principal Component Analysis (PCA) for the determination of a workable number of components / factors for the Heath, Jarrow, Merton (HJM) model
  8. Construction of the multi-factor no-arbitrage Heath-Jarrow-Merton (HJM) model.


EXCEL file:

The pre-packaged deal includes 6 EXCEL files that illustrate examples of the following concepts:

  1. Zero Coupon and Forward rate term structures derivation and construction (pre-requisite)
  2. Calibration of a CIR Model’s parameters to a historical rates data set
  3. Construction of a BDT model
  4. Utilization of the results of a BDT model
  5. Principal Component Analysis
  6. Construction of a HJM 3-factor model

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