8/17/22, 2:27 PM pricing - Which interest rate model for which product - Quantitative Finance Stack Exchange

Quantitative Finance

Which interest rate model for which product

Given the multitude of existing interest rate models (ranging from simple to very complex) it
would be interesting to know when the additional complexity actually makes sense.
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The models I have in mind:

Simple one factor (e.g. HW)

Two or one factor models with stochastic volatility

LIBOR-Market, HJM, SABR and SABR-LMM model

Are there any rules of thumb to decide which model to use for which product? (Perhaps
there is some book dealing with that topic that I am not aware of)

Edit 22.02.2014:

While trying to answer the question myself I found the follwing very interesting paper on the
emperical comparison of interest rate models. Here the authors mainly compare how well the
different models can fit market data and hit the relevant market pries after being calibrated.

Thus a follow up Question: (that is also related to the question on model validation)

Does it suffice to hit the market pries spot on after calibration for a model to
qualify for being used in pricing for an instrument ? Or are there other aspects to be
considered? (computational speed, statistical fittness, robustness of the hedges)

Let's assume my model fits the market data really well - backtesting however shows that the
hedges it provides don't work that well. Also the model might not be able to statistially fit the
path of the underlying. E.g. mean reversion can be observed in some markets but not in others.
One could argue that risk neutrality does not necessarily entail meaningful real-world scenarios
etc.

I have good theoretical grasp of the models but have mainly used them for risk management (thus
generating paths and analysing what happens to a portfolio or the balance sheet of an enterprise)

interest-rates pricing models

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Share Improve this question Follow edited Apr 13, 2017 at 12:46 asked Feb 19, 2014 at 8:25
Community Bot Probilitator
1 3,337 1 19 37

2 I look forward to hearing from someone with more front office experience than me, but the rule of thumb
as I understand it is that one must use a model that can capture the dynamics and risks to which your
product is exposed. So, a one-factor model is fine for a cap, since the cap is basically exposed to the risk of
the level of the yield curve, and that's it. However, it's not sufficient for a spread option, since the dynamics
of the spread can't be adequately modeled with one factor. I, too, would appreciate a more rigorous
reference for this though! – experquisite Feb 20, 2014 at 15:47

Still your explanation is a good start. I work alot with interest rate models in Risk-Mangement but here one
is mostly interested in the "real-world"-measure - whatever that might be. Most books I know only
introduce you to the instruments and don't give much advice when to use them. – Probilitator Feb 20,
2014 at 17:19

I have been googling for a while now - can't seem to find anything substential. The text book give me the
tools but not the manual to use them ... – Probilitator Feb 22, 2014 at 18:26

2 One criteria could be that the model produce realistic values. Hull-White for instance can lead to negative
interest rates. – Jonas K Mar 5, 2014 at 12:52

1 The model to use depends on the purpose of the pricing. If you're long and short caps at different
maturities, you need a model that captures the term structure of volatilities. If you are trading out of money
vols, then you need a model that captures the volatility vs strike dynamics. In reality the risk management
applies to the whole portfolio, thus you can say models should be most complicated to capture the
dynamics between the different factors. Though there is a trade-off of the model risk. – adam Mar 8, 2014
at 13:12

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2 Answers
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The model of choice depends on the purpose of the exercise. In general there are two types of
models:
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1. Equilibrium models: These are general used use for "fitting" the spot curve to the discount
function available in the market. So different models will give you different yield curves. One
can use this information to see the relative value of implementing a strategy. Examples are
Vasicek two factor model. Since the yield curve produced by these models will not be same
as the actual yield curve hence they are usually not used for derivatives pricing (you won't get
exact market prices of bonds using a calibrated model here).

2. Risk - Neutral models: These are the second class of models. They fit the current yield curve
exactly and are used to price derivative securities like caps/floors/swaptions etc. Libor Market
Models would fall in this category. Example, Black-Derman-Toy, String model (Longstaff-
Schwartz et al) etc. You can use BDT to construct binomial trees and get the price of the
derivative security. String model can be used to simulate yield curves using Monte Carlo
simulation and price securities in the process.
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8/17/22, 2:27 PM pricing - Which interest rate model for which product - Quantitative Finance Stack Exchange

On factors:

As per literature some researchers have used Principal Component Analysis on yield curve data
and found that for yield curve, almost all of variation can be captured using 4 principal
components: 1. Level (parallel shift) 2. Slope (tilt) 3. Curvature 4. Money Market Factor (short end)

Some complex models use some/all of these factors to model the yield curves.

Share Improve this answer Follow answered Jul 22, 2014 at 6:58
Taran
user 301 2 6

Well, it still doesn't really answer the question. – SmallChess Aug 21, 2014 at 4:25

@Taran could you elaborate further on examples between 1) and 2) models and how to spot them – Trajan
Sep 8, 2018 at 22:43

Here is a list of model attributes that are necessary for a derivatives model to qualify for use in
pricing and hedging: 1) exact fit to liquid yield curve inputs and good interpolation scheme in
3 between 2) good fit to relevant volatility inputs. (if a product has exposure to volatility points all
through the grid, then the model needs to fit well everywhere) 3) good fit to the market skew, if
relevant for the product 4) computation time is important if the portfolio is large 5) generates
reasonable hedges - note that the choice for the skew dynamic heavily inputs what hedges are
generated 6) the implementation is user friendly That's just a few

Share Improve this answer Follow answered Dec 8, 2015 at 19:36

yeah, I agree in general with this answer compared to the other one. Only other thing I would add (though
probably implicitly meant), is that, the stability of the prices/risks should be stable over the market-bumps
and stress scenarios. – Kiann Feb 4 at 16:13

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