Yield curve models are used to price a wide variety of interest rate-contingent claims. The existence of several different competing methods of curve construction available and there is no single standard method for constructing yield curves and alternate procedures are adopted in different business areas to suit local requirements and market conditions. This fragmentation has often led to confusion amongst some users of the models as to their precise functionality and uncertainty as to which is the most appropriate modeling technique. In addition, recent market conditions, which inter-alia have seen elevated levels of LIBOR basis volatility, have served to heighten concerns amongst some risk managers and other model users about the output of the models and the validity of the underlying modeling methods.
The purpose of this review, which was carried out in conjunction with research analyst Xu Bai, now at Morgan Stanley, was to gain a thorough understanding of current methodologies, to validate their theoretical frameworks and implementation, identify any weaknesses in the current modeling methodologies, and to suggest improvements or alternative approaches that may enhance the accuracy, generality and robustness of modeling procedures.