Markovian Single State Paradigm
Whole Yield Curve Paradigm
Positive Interest Rate Paradigm

Some Preliminary
Lattice Works
Determining the Drift and Matching the Initial Term Structure

Over-Determined Problem
Calibrating Instruments
Objective Function and Time Buckets

In-Arrears Swap (or Arrears Reset Swap)
Constant Maturity Swaps (CMS)
Forward Rate vs. Expected Spot Rate
Some Convexity Mathematics

Volatility is a very important component when valuing contingent claims which are dependent on
interest rates. Particularly when the contingent claim is long-dated, more complex or American
in exercise, the dynamic behavior of the volatility of interest rates spanning the claim period
cannot be neglected. This behavior is called the volatility term structure. For these complex
claims, a no-arbitrage model of the term structure of interest rate incorporating volatility
dynamics is essential.

This is easy to say but very difficult to implement in practice. The goal of this chapter is to
elucidate on the myriad issues that come up during the implementation of such an arbitrage-free
framework for valuing interest rate derivatives. The focus will be on volatility, in general, and
the practical dilemmas surrounding it.

The level of interest rate depends on the length of time for which it applies. For example,
funding for short term is necessarily different from that of either intermediate or long term needs.
The differences give rise to a variety of levels over the time horizon. Because of this, there is
a "term" effect in the dynamic behavior of interest rates. This variation of levels in interest rates
is known as the term structure of interest rates or more commonly (albeit incorrectly), theyield

In addition, because the evolution of future interest rates is uncertain, there is a random
component in its dynamics. The uncertainty, and hence the random component, in future
interest rates, is encapsulated in the associated volatility term structure, which is principally
responsible for the changes in the shape of the yield curve. If future interest rates were certain,
that is, no random components and hence zero volatility, the forward curve tomorrow will
maintain the exact same shape as the forward curve today but shifted forward by one day. Real
life experience tells us, however, that this is simply not true.