Parameterizing Interest Rate Models

Actuaries are now being called upon to incorporate interest rate models in a variety of applications, including dynamic financial analysis (DFA). ratemaking, and valuation. Although there are many articles and texts on interest rate models, most of these presume an understanding of financial terminology and mathematical techniques that makes it difficult to begin to learn this material. This paper provides an overview, at a level aimed at actuaries, of some common interest rate models used by financial economists. The purpose of this paper is to explain the basics of interest rate modeling by demonstrating the different models both graphically and empirically, and by showing how changing the various model parameters affects the results. Several of the more popular interest rate models are simulated and the results are compared with historical interest rate movements.