Chapter 2 - Term and volatility structures

Abstract

Term and volatility structures are the cornerstone to practically all valuations of fixed income financial instruments and consequently affects, or should affect, significantly the trading and the management of financial holdings; they are also used to help shape monetary policy by Central Banks. This chapter provides a review and a comparison of the methods that have been suggested to construct the term structure associated with a given collection of fixed income financial instruments. It addresses the problem of determining the (associated) volatility structure that has been given only scant attention in the literature. All valuations (discounted cash flow, instrument pricing, option pricing) and other financial calculations require an estimate of the evolution of the risk-free rates as implied by the term and volatility structures. This presumes that one has, if not perfect knowledge, at least very good estimates of these market term structures.