Historically, interest rate models have been the domain of finance professionals with advanced quantitative degrees called “quants.” The mission of these financial engineers is often solely to accurately value interest rate sensitive instruments for the purposes of trading or risk management, usually within large banks. However, an often overlooked yet straightforward application of interest rate models is equally beneficial to those managing rate sensitive liabilities in the modern municipal or tax-exempt corporation.
Why interest rate models are not used more frequently is an interesting question with no clear good answers, although there are culprits. First, these models are largely misunderstood, described in antiseptic, stark, mathematical terms, and as such are thought of as inaccessible and generally too complex to use. In fact, those who understand these types of tools often possess an inherent bias against making them better known because that would only dilute the value of their hard won knowledge.
Second, a model’s useful implementation often requires greater computing power and flexibility than the ubiquitous spreadsheet. Yet sadly for many finance professionals, the spreadsheet is the only flexible computational tool available. The third reason is more subtle and leads to an overlooked yet incredibly important simplifying assumption. This is explored in more detail in the paper.