Interest-rate term-structure pricing models: a review

The paper presents a review of interest-rate term structure modelling from the early short-rate-based models to the current developments. The emphasis of the paper is on the use of models for pricing complex derivatives or for relative-value option trading. Therefore, relative-pricing models are given a greater emphasis than equilibrium models. The paper argues that the current state of modelling owes a lot to how models have historically developed in the industry, and stresses the importance of 'technological' developments (such as faster computers or more efficient Monte Carlo techniques) in guiding the direction of theoretical research. In particular, the importance of the joint practices of vega hedging and daily model-recalibration is analysed in detail. The relevance of market incompleteness and of the possible informational inefficiency of derivatives markets for calibration and pricing is also discussed.