OVERVIEW OF ONE-FACTOR INTEREST RATE MODELS WITH THE FOCUS ON HULL AND WHITE

Summary: Given that interest rates affect the valuation and pricing of any financial product, much attention has been devoted to interest rate forecasting and yield curve construction. However, interest rate derivatives depend on the evolution of interest rates both in terms of present and future value of money, as well as through their dependence on the interest rate as the underlying ‘asset’. Consequently, several classes of models have been developed for pricing interest rate derivatives. Based on the variables they are attempting to capture, they are broadly classified as instantaneous rate or short-rate models, and market models. Although short-rate models are based on an unobservable variable, whilst market rate models directly reflect market rates and prices, the former are widely used in derivatives pricing, whereby - depending on their complexity and implicit assumptions and limitations - they are further classified as one-factor or two-factor models. This paper gives a brief overview of the theory underlying the one-factor interest rate modelling, with the specific focus on the advantages and disadvantages of Hull and White model.