Modelling the Term Structure of Interest Rates: A Literature Review

Abstract

The term structure of interest rates is an extremely important element in Finance. It is one of the most important indicators for pricing contingent claims, determining the cost of capital and managing financial risk. As a result; extensive research in this field has been developed. The purpose of this paper is firstly; to present the theories of the term structure of interest rates. Secondly; to describe some of the most important single, volatility and two-factor models of the term structure. Finally; to provide several frameworks in which interest rate models can be nested and compared between each other. Due to complex forecasting dynamics; little is known about the existence of a model able to outperform others. The model chosen will depend on the objective for which it is required. However; the most accurate models are those in which the levels of interest rate are related to fluctuations on volatility. We conclude that the most important elements in an interest rate model are the short term rate and volatility to changes in interest rates; consistent with Longstaff- Schwartz (1992) and Bali (2003). Furthermore; a two-factor model is accurate for modeling the term structure of interest rates.