Chapter 5: Information of interest
This chapter was originally published as: D. C. Brody & R. L. Friedman (2009) Information of Interest, Risk Magazine, December 2009 issue, pp. 105—110. Reprinted in Life & Pensions Magazine, February 2010 issue, pp. 35—40. Reprinted here with kind permission from Incisive Media.
IN THIS ARTICLE, we present a method of generating interest rate dynamics from elementary economic considerations. There are of course numerous economic factors that affect the movement of interest rates, and causal relations that hold between these factors are often difficult to disentangle. So, rather than attempting to address a range of factors simultaneously, we will focus on one factor important in determining the interest rate term structure, namely the liquidity risk, in the narrow sense of cash demand. The interplay between liquidity and interest rates has long been discussed in economics literature (see, for example, Friedman, 1968). Our objective is to build an information-based model that reflects the market perception of future liquidity risk, and use it for the pricing and general risk management of interest rate derivatives…
