MY GOAL IN WRITING THIS BOOK

In this book I intend to look at yield-curve modelling from a ‘structural’ perspective. I use the adjective structural in a very specific sense, to refer to those models which are created with the goal of explaining (as opposed to describing) the yield curve. What does ‘explaining’ mean? In the context of this book, I mean accounting for the observed yields by combining the expectations investors form about future rates (and, more generally, the economy) and the compensation they require to bear the risk inherent with holding default-free bonds. (As we shall see later, there is a third ‘building block’, ie, convexity.)

This provides one level of explanation, but one could go deeper. So, for instance, the degree of compensation investors require in order to bear ‘interestrate risk’ could be derived (‘explained’) in more fundamental terms from the strategy undertaken by a rational, risk-averse investor who is faced with a set of investment opportunities and wants to maximize her utility from consumption in amultiperiod economy. I will sketch with a broad brush the main lines of this fundamental derivation, but will not pursue this line of argument in great detail. The compensation exacted by investors for bearing market risk (the ‘market price of risk’) will instead be empirically related (say, via regressions) either to combinations of past and present bond prices and yields, or to past history and present values of macroeconomic variables.

Another way to look at what I try to do in this book is to say that I describe the market price of risk in order to explain the yield curve. If one took a more ‘fundamental’ approach, one could try to explain the market price of risk as well, but would still have to describe something more basic, say, the utility function.