ABSTRACT
This chapter discusses the concept of no-arbitrage in the interest rate markets, which is also referred to as the bond market. Bonds are essentially simple options, but they are tremendeously important for estimating the interest rate over a long period of time. This is called the term structure of interest rates and it provides the foundation for computing the present value of future payments. The chapter derives the term structure of interest rates using the classical approach. It considers specific models of the term structure of interest rates based on the interest rate models. It briefly discusses the so called Heath-Jarrow-Morton framework for modelling the forward rates. The chapter introduces counterparty risk in a risk-neutral framework, which can be used to price the basic credit derivative, the Credit Default Swap, but can equally well be used to value hybrid derivatives combining credit and market risks.
