Interest Rate Markets

Chapters 3 and 8 treat the interest rate, which appears in the fundamental formulas therein, as fixed and observable from the current yield of a short-maturity Treasury bill. However, similar to volatilities of asset returns, which are regarded as fixed (but unknown) parameters in the theory of single-period investments in Chapter 3 but are treated via time series models in Chapter 6 for other applications, interest rates also vary over time, and time series models of interest rates have been developed and used in interest rate markets to forecast future interest rates and to price and hedge interest rate derivatives. An additional complication of interest rate markets is that there are actually many interest rates at a given time: interest rates for different maturities, fixed versus floating rates, short rates versus forward rates, etc.; see Section 10.1. An overview of interest rate markets and basic concepts, such as present value, LIBOR, caps and floors, interest rate swaps, forward rates and short rates, and the zero-coupon yield curve, is given in Section 10.1.