Need for Interest rate models

[VK95]

Hi All,

I see the BS option pricing formula. It shows how to calculate the price of an option. Among others we need interest rates at a particular time and the volatility, so we can calculate the price of an option everyday based on the market rates available. Even in case of Interest rate swaps, for valuing them, i believe we need Interest rate curves.

I am not able to understand why we need Interest rate models(They predict interest rates is what i understand. Different ways of predicting it,with limitations and assumptions). Are they used in pricing or Monte Carlo Simulations?

1)Why do we need to predict interest rates?
Is it because we dont have interest curves for those period? Or some other reasons too?
2)Can anyone explain how are these predicted interest rates used, with an example in real world?

Sorry if its too basic. I am not from a Maths background. Should i learn calculus to understand this?

Thanks in advance.

 

[ami44]

Hi VK95,

Interest rate models are not used to predict future interest rates. They can’t tell you if interest will go up or down. What they do is providing a stochastik description of the dynamic of interest rates. I.e. they tell you which moves are possible with what probability.

The BS Modell is for equity options. It models the dynamic of the underlying stockprice as lognormal. For interest rates this would not be appropriate. Thus the need for interest rate models. Once you have such a model you can price options on interest rates e.g. swaptions.