I. Interest rate risk: anticipating the future and relying on the collective wisdom of the internet
Have you ever watched smoke dissipate into the air in a perfectly still weather? What do the movement of particles of such smoke and the movements of the floating-interest rate on mortgage loans have in common? Well, banks price contracts based on interest rate using dynamics models that are almost identical to the ones used by physicists to model the movement of smoke dissipating into a still environment. Each single smoke particle bombarded with billions of air particles undergoes diffusion as described by the random walk model. The same rule applies to the market interest rate ‘driven’ by decisions, usually made independently by hundreds of thousands of money market participants.