Interest rate modeling for risk management : market price of interest rate risk

Abstract

This book introduces a theoretical framework - the ‘real-world’ model - that allows us to estimate the market price of interest rate risk based on practical and real life situations. The model can be briefly summarized as a process of estimating the market prices of risk through discretization of forward rates with a ‘space-state setup’ whilst considering historical data trends. The book starts with a brief explanation of interest rate stochastic analysis fundamentals before delving into standard models such as Heath-Jarrow-Morton, Hull-White and LIBOR models. The real-world model is then explained in subsequent chapters while applying different frameworks. Additionally, the book also explains some properties of the real-world model, along with the negative price tendency of the market price for risk and a positive market price for risk (with an example of this actually occurring). Readers will also find a handy appendix with proofs to complement the numerical methods explained in the book. This book is intended as a primer for practitioners in financial institutions involved in interest rate risk management. It also presents a new perspective for researchers and graduates in econometrics and finance on the study of interest rate models.