THE PROBLEM
Because interest rate models are central to many practices in the capital market, they should be transparent and validated. However, most models today remain black boxes—providing no simple way for users to check the specifications or the intuitive explanations of the model. Transparency is particularly important because model efficacy may depend on the interest rate regime and the financial instruments being analyzed.
The specifications and explanations should include the following:
1. Rate Surface
The Rate Surface is the stratification of the probabilities of the short rate reaching a particular range of rates. Rate stratification can be used to determine structured sampling for stress-test and path-dependent instrument pricing. Any sparse sampling of interest rate paths in valuing path-dependent instruments must consider the relevant interest rate region for the valuation of the instruments.
2. Model Specification
Model specification should be relatively simple while ensuring the model remains robust. The model should be specified by five parameters: short-term volatility
a) short-term increase or decrease of volatility
b) the decay of the volatilities over time
c) the long-term volatilities
d) the skewness of the binomial distribution
b) the decay of the volatilities over time
c) the long-term volatilities
d) the skewness of the binomial distribution
In Summary
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