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Stochastic Modelling of Interest Rate Dynamics: An Expository Note

Diliman Review
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  • Economics


8MAMON 197 Stochastic Modelling of Interest Rate Dynamics: An Expository Note Rogemar S. Mamon T his paper discusses the modelling of the term structure of interest rates, which refers to the relationship between the interest rate and the term to maturity of an underlying financial instrument such as a zero-coupon bond, a Treasury-note or a Treasury-bill. Interest rate modelling plays an important role in economic and financial theory and has long been a topic of concern to economists. On the microeconomic level, interest rate is the most significant risk that any financial institution has to cope with. Therefore, an understanding of the yield curve movement is necessary in pricing interest rate sensitive securities and in the management of the associated interest rate exposures. Knowledge of interest rate dynamics is also invaluable to market practitioners. Market rates such as returns on risk-free and liquid securities (e.g. non-callable US Treasury bills and bonds) are used by investment banks as benchmarks for examining other key financial rates. As well, term structure of interest rates is of a paramount importance to corporate treasurers, who must decide whether to borrow by issuing long- or short-term debt, and to investors who must decide whether to buy long- or short-term bonds. On the macroeconomic level, previous research studies show that a forecast of economic growth can be made based on the short-rate and long-term interest rate behaviours. 198 Stochastic Modelling Statistical investigations have documented modest, but reliable positive correlations between the slope of the term structure (differences between long- and short-term interest rates) and futures of economic growth. This is further substantiated in Bomhoff (1994), Estrella and Hardouvellis (1991), and Harvey and Campbell (1991). In addition, findings from previous studies reveal that the term structure of interest rates can reasonably det

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