ABSTRACT
This chapter presents the preliminaries of the model. As is true of all models, the model selected for presentation is an abstraction from reality. It is an abstraction because it is a simplification. It is simplified in order to facilitate understanding and analysis. Of course, the hope is that the simplified model is still a good approximation to the actual economy. The approximation needs to be good enough to provide both (i) accurate valuation of interest rate options and (ii) accurate synthetic construction of the cash flows to interest rate options using the traded Treasury or Eurodollar securities. How accurate the valuation and the synthetic construction need to be is determined in each application. Our experience, however, is that this model and its extensions are accurate enough to have proven quite useful in the actual trading and risk management of fixed income securities and interest rate options.
